Affluenza

By Eric J. Fry

Warning: A virulent epidemic is sweeping the nation.

How many more victims the epidemic might claim is anyone’s
guess. But suffice to say that the rapid spread of this
contagion is a serious national problem, which may produce
several dire consequences…like falling home prices, for
example.

Although the disease manifests itself in a variety of ways,
it often produces behavior characterized by reckless
borrowing and insatiable consumption. The disease, known as
"affluenza," has infected millions of Americans already,
but has reached epidemic proportions among California
homeowners.

The onset of symptoms is often accompanied by a sense of
euphoric invulnerability. Unfortunately, this delusional
rapture promotes additional high-risk behavior, which
usually worsens the infection. Many victims succumb to the
disease, but the condition is treatable. Early diagnosis
can promote a highly efficacious response. Curtailing high-
risk activities, for example, can reduce the infection and
– sometimes – restore the infected host to an asymptotic
state known as "solvency."

But many folks – because they are oblivious to their
condition – continue borrowing and spending until the
disease reaches its final and most serious phase, also know
as "insolvency."

We are not anticipating a widespread outbreak of
insolvency. More likely, the growing awareness of the risks
posed by affluenza will inspire a gradual return to low-
risk behavior, like saving money and re-paying debts.
Sadly, such practices, while healthy for the individual,
are highly toxic for the national economy and for the
country’s over-inflated real estate markets.

But that’s a problem for another day. Let’s take a quick
peak at the current state of the epidemic…

(Forgive us, dear reader, for directing our financial gaze
once more toward the west, specifically toward Orange
County, California. It’s not our fault that the county’s
many quirks recommend themselves as fodder for the Rude
Awakening.)

Orange County is a bastion of wealth – the real kind. But
it is also a bastion of "faux wealth" – the kind that
subsists on a cocktail of high-risk borrowing and
perpetually appreciating home values.

"Orange County has evolved into a metropolis fit for a
marquee," writes Scott Duke Harris for the L.A. Times
Magazine. "Once a humble supporting character in the great
American drama, it now comes across as an action hero on
steroids, all pumped up and shiny for the 21st century with
a swaggering prime-time sobriquet: ‘The O.C.’

"OC is all about the good life now," Harris continues, "and
livin’ it extra-large…Orange County is a hot-zone for a
contagious social condition that compels people to live
beyond their means."

One ad agency exec interviewed for the LA Times story
refers to the county’s conspicuous consumption as
"affluenza." The effects of the disease are showing up in
the county’s housing market, where the median home price
has doubled over the past five years to a whopping
$660,000.

If this manic home price appreciation were powered by a
corresponding income growth, we might have little cause for
concern…But it is not.

Instead, home prices are booming on the back of a related
boom in high-risk mortgage lending, especially interest-
only (IOs) mortgage lending. As the graph below
illustrates, interest-only loans in California were
virtually non-existent four years ago, but comprised nearly
half of all mortgage originations last year. Orange County,
itself, has witnessed a similar surge of IO financing, as
has the entire nation.

"Measured as a percentage of [nationwide] jumbo-loan
originations," James Grant recently observed, "IOs have
climbed to 70% at year-end 2004 from less than 20% in early
2002."

The most worrisome aspect of the current home-price boom,
therefore, is that it relies mostly on easy access to
innovative – read: risky – mortgages, rather than incomes.

To be sure, some Orange County residents require no
mortgage lender to finance their home purchases. Bond fund
king, Bill Gross, for example, who operates his multi-
billion dollar operation from Newport Beach, does not
require an exotic, IO loan to underwrite his lifestyle. But
most OC residents carry a smaller billfold than Bill Gross.
If they are to live the OC dream, therefore, they must
secure the necessary funding from somewhere other than
their weekly paychecks.

"The work-and-spend treadmill is particularly intense in
‘pleasure domes’ such as Orange County," Haris reports.
"Daily life here is a constant reminder of things you don’t
have – yet."

Enter the mortgage-banker, like a new-age Mephistopheles,
to offer a seductive proposition:  Borrow a bundle of
money, spend most of it on earthly delights, and don’t
worry about repaying the debt…until later.

During the early years of an interest-only mortgage, the
borrower pays only interest on the loan and none of the
principal. Unfortunately, this delightful arrangement comes
to an end eventually, in which case the borrower’s monthly
payments rise dramatically.

"Three to five years down the road," explains William Batz,
executive vice president of Federal Home Loan Bank of
Pittsburgh, "when the principal payments kick in, and
keeping in mind that now you’re looking at amortizing the
principal over 25 years rather than 30 years, you get a
real bang at that point."

Now that IOs have become mainstream, the future days of
reckoning loom large. What happens when millions of
homeowners find themselves in a pay-or-quit situation? What
happens when millions of homeowners must begin making much
larger monthly mortgage payments or lose their homes?

We would guess that two consequences, at least, will
result: Consumption will slow dramatically and home prices
will fall…perhaps dramatically.

"Even as [many] mortgage executives celebrate the
industry’s use of innovative products aimed at getting more
people into homes," MarketWatch relates, "they express
concern that some home buyers are using adjustable-rate
mortgages, interest-only loans and other products without
fully understanding the inherent risks."

"’One of the things we don’t feel good about right now as
we look into this marketplace," Thomas Lund, senior vice
president at Fannie Mae, tells MarketWatch, "is more home
buyers being put into programs that have more risk…Does
it make sense for borrowers to take on risk they may not be
aware of? Are we setting them up for failure?"

No, and yes, would be our respective guesses.

"To the extent that credit conditions are driving home
price trends," FDIC economists Cynthia Angell and Norman
Williams placidly observe, "the implication would be that a
reversal in mortgage market conditions – where interest
rates rise and lenders tighten their standards – could
contribute to the end of the housing boom."

That event would be enough to make anyone feel sick…but
cash might be an effective antidote.

Did You Notice…?
By Eric J. Fry

"In many U.S. cities, the housing market looks as
extravagant and top-heavy as a Dr. Seuss castle,"
BusinessWeek recently observed, "In metro New York, the
median price of a single-family house is up 78% since 1999,
according to the Office of Federal Housing Enterprise
Oversight. The gains are even bigger in Miami (87%), Los
Angeles (97%), and San Diego (115%). For years house prices
in these markets have risen faster than family incomes."

But in spite of the fact the income growth in trailing well
behind home-price growth, many homebuyers have elected to
INCREASE their mortgage liabilities. San Diego homebuyers
are a case-in-point.

The chart above illustrates the frightening interplay of
high-risk home buying, soaring property values and stagnant
incomes. Mortgage payments have nearly tripled, while
incomes have increased very little over the same timeframe.

Equally troubling is the fact that mortgage payments have
been soaring despite a pronounced drop in interest rates.
Evidently, San Diego homebuyers have been squeezing into
the most expensive homes that they can theoretically
afford. So far, this recklessness has produced no serious
consequences. But the picture above does prompt the
question: what happens if interest rates rise?

And the Markets…