The Housing Bubble

The LA Times reports on the boom in interest-only mortgages in California.

Interest-only loans, and other forms of so-called creative financing that are far riskier than the traditional 30-year fixed-rate mortgages, have allowed more people to afford homes in California even as prices have skyrocketed.

When the price of houses in California soared 17% in 2003 and 22% in 2004, a curious thing happened: Instead of home ownership decreasing because fewer people could afford houses, it rose to record levels.
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An interest-only loan offers the ability to defer for three, five or seven years any payment for the house itself. That allows a potential buyer to stretch to afford a place that otherwise would be out of reach.

Of course, everyone else using an interest-only loan can stretch too. The result is that prices keep rising. That, in turn, encourages still more people to use interest-only mortgages, which fuels still more appreciation.
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What's propelled the market up in California, some experts worry, could just as easily speed its descent.

"In the last few years, rates went down and values went up. It's like you were paid to live in California," said analyst DeFranco, who works for LoanPerformance. "People got so used to refinancing. They'd think, 'No problem. My house will be worth twice what I paid, and I'll refinance my way out of trouble.' That's not going to be a good approach going forward."

Here's how he thinks a collapse could occur: Rising interest rates put a brake on price appreciation and refinancings. People realize their interest-only period is coming to an end, raising their monthly payments substantially. Since they have no equity in the house, they choose to default.

"If housing prices go down or even are flat, heaven help us," said DeFranco.

I'm continually amazed to see new McMansions popping up all over the place. On the Biodiesel Bus Tour last week, we went from Lansing to Flint to Pontiac to Ann Arbor. Of these cities, only Ann Arbor could be said to have anything like a healthy economy. Several recent articles have highlighted the dire financial trouble that Michigan is in. Still, there are new subdivisions everywhere. And not only are many of these people not going to be able to pay off their mortgages when interest rates go higher and the economy stagnates further--the houses themselves will become unaffordable at almost any price because they are completely dependent on cheap gasoline and electricity.

My brother tells me that the same thing is happening in California's central valley--low-mortgage-rate sprawl with SUV's scurrying about like ants in an ant farm. When this bubble bursts, which it will soon, it's going to burst hard.