In Arms' Way

Lenders have been pushing adjustable rate mortgages to the most unsuitable borrowers at the most unsuitable time. Disaster can’t be far away even if house prices keep rising

Contrary to popular rhetoric, given today’s interest rate environment there are no circumstances for which homebuyers should choose adjustable rate mortgages (ARMs). That so many people are currently opting for ARMs reflects a level of real estate speculation unparalleled in American history.

Homebuyers have been lured into this foolish choice by real estate and mortgage brokers eager to earn commissions, their own avarice in pursuit of easy riches, and by a fed chairman desperate to keep the real estate bubble inflating. Unfortunately, the longer the Fed remains "patient" with regard to raising short-term interest rates, the more homeowners will be lured into the ARM time-bomb.

One argument is that, by using ARMs, "savvy" homeowners save money because the months of lower payments will be more than offset by higher payments in the months following the interest-rate hikes. This ignores the fact that – when those higher payments ultimately arrive – most borrowers may not be able to afford them. After all, it is not as if they are saving the money that otherwise would have been spent on higher fixed-rate mortgage payments. The typical borrower is already max’ed out with the current low payment, and hopes to meet any higher future payments by extracting appreciated equity.

Adjustable Rate Mortgages: Selling Quickly

The most popular justification for choosing an ARM (other then the fact that many borrowers simply do not qualify for a fixed rate) is the buyer’s intention to sell the house in a short period of time, say 2-3 years. The rationale goes something like this: if buyers will be selling their houses in only 2 or 3 years, then why pay the higher interest costs of a 30-year fixed-rate mortgage?

First of all, the fact that people buy houses with the intention of selling them on again in only 3 years, is itself one of the best signs of the speculative nature of the current real estate market. Those doing so are speculating on price appreciation, plain and simple.

Such individuals would be far better off renting, especially given today’s high housing prices, transaction costs, and relatively low rents. One of the main arguments against renting is that renters "throw away money on rent."

Forgetting for a moment that one no more "throws away money on rent" than one does on food, clothing, or any of life’s other necessities, individuals buying and selling houses for speculation (since no payments of principal are made) are throwing away money on interest, real estate commissions, loan and closing costs, taxes, insurance, maintenance, and moving expenses. Therefore, not only should individuals that plan on selling their houses in the near future explicitly not use ARMs, they should not even be taking out mortgages. They should be renting! (Unless they are speculating that the property will appreciate by a sufficient margin to cover all the additional costs.)

Adjustable Rate Mortgages: Sell and Rent or Sell and Buy Elsewhere

Short-term home-seekers should choose from one of only two possible plans. Sell and rent, or sell and buy elsewhere. However, if you listen to real estate brokers, most are planning to sell current purchases in just a few years’ time, so that they can trade-up for houses of greater value than the ones they can currently "afford." The money to buy these more expensive houses (which, if the desired scenario pans out, will become even more expensive) will come from the equity accumulated in the "starter" home. In other words, buyers are still speculating on price appreciation.

Assuming today’s short-term buyers put their houses on the market, who will buy them, especially if interest rates have risen? If the current crop of buyers has relied on low-interest ARMs and lax lending standards to qualify for their mortgages, how will future, similarly situated, buyers qualify when interest rates are higher and lending standards are stricter? And what if the current short-term buyers cannot sell their houses in the future…how will they afford to move? Even if they can sell, how will they be able to afford the increased interest payments on yet more expensive houses, given that interest rates will likely be higher?

Therefore, short-term buyers may very well end up living in their houses for much longer periods then they initially imagined, unless of course, they lose their homes in foreclosure (in which case they become renters).

Buying a house used to represent a long-term commitment to the bank, a place to raise children and a place to grow old. This concept is completely lost in today’s world of short-term ARMs and interest-only mortgages. Equity accumulation, traditionally the main advantage of homeownership, is being diluted. Real equity is accumulated through the reduction of mortgage.

However, in today’s real estate bubble, principle payments are rarely made. Modern homeowners have become fixated on the idea that equity accumulates though price appreciation alone.

Adjustable Rate Mortgages: Accumulating Debt

In the perverse world of "starter homes" and "trading up," the reality is that homebuyers accumulate greater and greater amounts of debt.

Instead of reaching retirement age with a home that has been paid for in full, a critical element to comfortable retirement, today’s homeowners will still be struggling with debt.

Sure, they might find that a proportion of equity has accumulated through price appreciation (assuming the equity hasn’t been tapped by cash-out refi’s) but will that equity really exist when homeowners come to sell?

Those who argue that real estate is not in the grips of a bubble, typically have a vested interest in seeing the bubble continue. The biggest boosters have been those that make their living in the real estate industry (or in one of the many industries it supports), or those that own real estate.

Those arguing that rising interest rates will not affect home prices are living in some self-serving, delusional, alternate reality. Pundits, who point to the fact that rising interest rates in the 1970’s did not lead to significant price declines in real estate, are comparing apples to oranges. They fail to take into account the proliferation of adjustable rate mortgages, and the fact that so much of the "equity" accumulated during the bubble has already been cashed out. They fail to take into account the other economic variables, such as the fiscal and current account imbalances, and the high debt levels and low savings rates so prevalent in the highly leveraged, de- industrialized, modern American economy.

The real losers in this whole fiasco are likely to be those who did not even participate in the mania. It will be the American savers who suffer, whose retirement dreams will vanish in a cloud of hyperinflation.

As over-leveraged borrowers walk away from properties in which they have no equity, the Fed will most likely attempt to bail out both debtors and bank depositors (and the government sponsored enterprises that insured the loans) with the most inflationary monetary policy ever undertaken in the history of central banking.

The savings of an entire generation will be wiped out, as they will have been squandered in order to perpetuate the biggest real estate and consumer debt bubbles of all time.


Peter Schiff
for The Daily Reckoning
June 3, 2004

Editor’s Note: Interest rates could begin rising as soon as June 29. The serious implications for the housing market are essential knowledge for all homeowners; see our special report:

The total destruction of the U.S. housing market

Peter Schiff C.E.O. and Chief Global Strategist of Euro Pacific Capital. He has been quoted in the Wall Street Journal, Barron’s, Investment Business Daily, CNBC and now The Daily Reckoning.

In ARMs’ way.

Tout Baltimore is talking about it.

"I know a guy who bought one of those sorry houses around Paterson Park," began a friend yesterday. "He paid $87,000. He sold it for $140,000 to someone else – even before he settled on it."

Baltimore is not exactly Paris. And Paterson Park is not exactly Le Jardin de Luxembourg. Instead, it’s a place where you used to be able to commit suicide without having to buy a handgun or slash your wrists. You just had to go for a stroll in the park after dark; chances are you’d never come back.

‘Must be another suicide,’ the cops would say. ‘Nobody’s that dumb.’

But for everything there is a season, as we like to say here at the Daily Reckoning office…and a crime for every purpose under heaven.

It is the ‘silly season’ in Baltimore. Housing – ignored, neglected, forgotten for more than half a century – is suddenly fashionable. People are paying extravagant prices for very modest dwellings. Houses that no one wanted to own for years, suddenly find several owners in a single year; they are flipped and re-flipped before anyone ever moves in.

And the crime that people are talking about in Baltimore is not one that Elliot Spitzer would be likely to prosecute: Alan Greenspan has created a bubble in property prices…even here in Charm City, house sellers are getting ‘excessive compensation’ for their pathetic hovels.

"Groups of investors are coming in from Washington. And there is even one group from Chicago. They’re buying up whole blocks and fixing them up. Areas that you wouldn’t drive in – even with your windows rolled up and your doors locked – are now becoming quite pricey."

The trend has left the town’s newspaper reporters gasping for explanations. Prices are rising in one area because it is "close to the harbor." In another, because of its "old- fashioned charm." Still another area is soaring in price because "it has been discovered by the city’s young and hip community."

Of course, a few years ago you could have bought the charm and proximity for half the price. No one bothers to wonder about the real source of the bubble.

"History is just a record of the crimes, follies and misfortunes of mankind," wrote Edward Gibbon. Baltimore’s row-house bubble was inspired by Greenspan’s crime…and has led to the public’s delightful folly. The Fed chairman is increasing the money supply at a breathtaking pace, and Baltimore’s speculators think they are getting rich by selling houses to one another. The misfortune of it all lies ahead.

"It is unbelievable," another friend took up the conversation over lunch. "My husband and I decided to buy a house. We went out to look, but the prices seemed much too high. I’ve only been here two years, but in that time, prices seem to have doubled on the type of place we wanted. Everyone we know seems to be speculating on houses now. They’ve driven up prices to senseless levels. We can’t buy one, because we don’t want to speculate; we just want a place to live. I guess we’ll just have to wait until this madness passes."

When will it pass?

We don’t know. But we suspect we know how: painfully. More people own houses than ever owned stocks. And they’ve leveraged their houses with more and more mortgage debt at adjustable rates. They’ve put themselves in ARMs’ way…the poor schmucks.

Over to Eric for more news…


Eric Fry, from Midtown Manhattan…

– The Big Apple seemed a little flashier than usual, yesterday, as the New York Gold Show rolled into town. Gold bugs from all over the tri-state area fluttered to the show like moths to a bonfire. The locals at the nearby New York Mercantile Exchange welcomed the out-of-towners by scorching the gold market for a 3-dollar loss to $391.15…you could almost smell the singed wings, as the HUI Gold Bugs Index fell more than 1%.

– Meanwhile, the dollar and the stock market both muscled their way back from morning losses to afternoon gains. The greenback slipped past $1.23 versus the euro, early in the day, but closed out the New York session with a slim gain at $1.222. The Dow also slumped early on, but then charged higher to end the day with a 60-point gain at 10,262. The Nasdaq slipped two points to 1,989.

– A huge reversal in the price of crude oil cleared the way for stocks like a machete hacking through swamp grass. The oil price fell $2.37 to $39.96, erasing nearly all of the prior day’s $2.45-gain.

– The proximate cause of the sell-off was word from Kuwait’s oil minister, Sheikh Ahmed Fahd al-Ahmad al-Sabah that OPEC will boost production sufficiently to "bring the price down slowly over the next two weeks by $6 to $8 a barrel."

– The sheikh’s precise prediction seemed to rattle oil investors, who brought the oil price down faster than you can say, "Sheikh Ahmed Fahd al-Ahmad al-Sabah." Maybe the sheikh will be proven correct, or maybe the oil price will fall further and faster that he imagines. Or maybe – and wouldn’t this surprise the sheikh – the price of oil will resume its rally.

– We certainly have no inside knowledge, but we suspect we have not seen the last of $40 crude oil.

– Today at the Gold Show, your Paris editor will take the podium as the day’s keynote speaker, while your New York editor will be jostling for a good view and taking copious notes…and if he hears anything intelligent from the podium, he will dutifully report it. If not, he will report it anyway.

– "Whither the stock market?" your New York editor asked options pro, Jay Shartsis yesterday.

– "The market does whatever it wants…or doesn’t want," the seasoned veteran replied, "and right now it doesn’t want to pay much attention to skyrocketing oil prices or Iraq or Saudi Arabia or the terrorists. I remember back in 1968, easily the most tumultuous year in the post-World War II period, when there was serious rioting in major American cities and, at one point, parts of Washington D.C. were burning, the market decided to celebrate the occasion by rallying sharply…so the market’s surprisingly positive reaction to the weekend’s unpleasantries is probably all we need to know right now to discern its buoyant mindset."

– Today’s market is not exactly "rallying sharply," as the Dow and Nasdaq are both still underwater for the year. But the market does seem to possess a "buoyant mindset." Clearly, share prices could easily be much lower than they are, given the soaring level of interest rates and the surging price of oil.

– Truth be told, however, the market is really of two minds…or two personalities. Let’s call one of them, Mr. Big Cap and one of them Mr. Small Cap. As Mr. Big Cap, the market is holding up very nicely, withstanding the "woes of outrageous fortune" like record-high oil and gasoline prices. As Mr. Small Cap, however, the guy’s a complete wreck.

– "Below the calm surface of the indices, there has been a strong enough undertow for investors to lose plenty in individual stocks," observes Barron’s Michael Santoli. "Going into last week, Smith Barney strategists had calculated that the average decline from the 2004 high in stocks comprising the S&P 1500 (encompassing large and small stocks) was 16%. The average drop from their 52-week high was 18%."

– So there’s been plenty of ways to lose money, even in a market that’s "unchanged" for the year…we predict Mr. Big Cap and Mr. Small Cap will both discover more ways for investors to lose money before the year is over.


Back in Baltimore…

*** It used to be said that you could predict the stock market by the length of a woman’s skirt. The shorter the skirt, the hotter the market.

Now, we may have an improved indicator. AP tells the story of the media’s newest darling, Miss Modesty. Eleven-year old Ella Gunderson, frustrated with all the ‘low-cut hip- huggers and low-cut tops’ on display in stores, has written to the executives of Nordstrom to complain.

According to the prudish Ms. Gunderson, many youngsters have become fed up with such racy teenage clothing: "There is just sensory overload. Kids are going to say ‘enough already,’" commented a busy body at Buzz marketing. "The next big trend I see is kids are going to look like monks."

Investors take note…

*** A colleague passes this bit of a-political humor:

A little boy goes to his dad and asks, "What is Politics?"

Dad says, "Well son, let me try to explain it this way: I am the head of the family, so call me ‘The President’. Your mother administrates the money, so we’ll call her ‘the Government’. We are here to take care of your needs, so we will call you ‘the People’. The nanny, we will consider her to be ‘the Working Class’. And your baby brother, we will call him ‘the Future’. Now think about that and see if it makes sense."

So the little boy goes off to bed, thinking about what Dad has said. Later that night, he hears his baby brother crying, so he gets up to check on him. He finds that the baby has soiled his diaper.

So the little boy goes to his parent’s room and finds his mother sound asleep. Not wanting to wake her, he goes to the nanny’s room. Finding the door locked, he peeks in the keyhole and sees his father in bed with the nanny. He gives up and goes back to bed.

The next morning, the little boy says to his father, "Dad, I think I understand the concept of politics now."

The father says, "Good, son, tell me, in your own words, what you think politics is all about."

The little boy replies, "The President is screwing the working class while the government is sound asleep. The people are being ignored, and the Future is in deep $#*%."

The Daily Reckoning