The Day of Reckoning on the Home Front

This just in -- the latest government report shows a strong jobs growth:

U.S. employers added an unexpectedly large 248,000 jobs in May, according to a government report on Friday . . .

The May tally exceeded Wall Street expectations for 216,000 new jobs and followed an upwardly revised total of 346,000 jobs in April and 353,000 in March. The 947,000 jobs created in the March-May period made it the strongest for any three months in four years. . . .

Nearly 1.2 million jobs have been added since the start of the year, adding fodder for a campaigning Bush to blunt Democratic criticisms fueled by the slow recovery from the 2001 recession. (Reuters, "Jobs Growth Unexpectedly Strong in May," June 4, 2004)

Doug Henwood of the Left Business Observer declares: "No one can call this a jobless recovery anymore" (LBO-talk, June 4, 2004). Good news for job seekers for the last couple of months, however, has yet to bail out the President of the United States, due to Iraq, gas prices, and "wage recession": "[W]hile U.S. corporate profits jumped 32 percent in the 12 months ended in March, the biggest increase since 1984, according to Commerce Department figures, average hourly pay of production workers rose 2.2 percent in the year through April, the slowest pace for that period since 1987. After accounting for inflation, the gain was 0.5 percent, according to the Bureau of Labor Statistics" (Art Pine and Brendan Murray, "Bush Economy Gains Fail to Excite Amid Iraq, Gas Rise," Bloomberg.com, June 1, 2004). See, also, Christopher Farrell, "Bush Is His Own Worst Enemy" (BusinessWeek, June 4, 2004).

The question is what will become of heavily indebted Americans once the Federal Reserve raises interest rates -- which is long overdue in the opinion of investors (Cf. Craig Torres, "Fed Should Have Raised Rates by Now, Investors Say," Bloomberg.com, May 4, 2004; Gretchen Morgensen, "Will the Fed's Slow-Mo Approach Backfire?" New York Times, May 30, 2004) -- and, more ominously, if the housing bubble bursts rather than slowly deflates:

Philo Thompson is 28, single and like many other Americans these days -- not afraid to stretch when it comes to buying a house.

A management consultant in Denver, Mr. Thompson bought a $500,000 townhouse last Friday in the suburb of North Cherry Creek.

As many other first-time homeowners have done, Mr. Thompson put no money down. Instead, he took out a first mortgage for 80 percent of the purchase price and paid the rest by taking a home equity loan against the new house. To reduce his monthly payments, and to qualify for a big enough loan, he took out an adjustable rate mortgage that requires him to make only interest payments.

People like Mr. Thompson could get squeezed if interest rates start to rise. With economic growth looking strong and hints of inflation in the air, Federal Reserve officials have made it clear that the era of extraordinarily cheap money is slowly drawing to a close. Yet Mr. Thompson betrays no worries.

"I'm too young to be scared," he said last week, betting that both the value of the house and his income will keep rising. If the bet fails, he said, it will not be the end of the world, adding: "There is a difference between being poor and being broke. Being broke is more of a temporary condition. Donald Trump has been broke a couple of times."

Mr. Thompson is not alone in such thinking. After a three-year period when the Federal Reserve cut interest rates to their lowest level since 1958, Americans have become far more willing to load up on debt and banks have become far more willing to let them.

Household debt climbed at twice the pace of household income from the beginning of 2000 through 2003, according to data at the Federal Reserve. Enticed by low interest rates, Americans took on $2.3 trillion in new mortgage debt during that period -- an increase of nearly 50 percent. Consumer credit, from zero-interest auto loans to the much more expensive debt on credit cards, climbed 33 percent, rising to $2 trillion in 2003 from $1.5 trillion in 2000.

Alan Greenspan, the Federal Reserve chairman, has repeatedly argued in recent months that rising household debt poses few problems. Fed officials note that the financial position of American households is, in some respects, stronger than ever. The value of household assets -- from resale prices of homes to the size of stock portfolios -- has increased even faster than debt.

Indeed, the collective net worth of American households is now higher than it was before the stock market bubble burst four years ago.

And thanks in part to lower interest rates, monthly debt payments consume a smaller share of monthly income today than in late 2001. . . .

But household debt could soon start to pinch. Fed officials . . . have made it clear that they must eventually raise rates. . . . [T]he main question is whether the move will come this summer or be delayed until early next year.

Regardless of when it happens, economists predict that a significant rise in interest rates will come as a jolt to many people. Those with home equity loans will see their monthly payments climb almost immediately. Adjustable mortgages will increase more slowly, because many borrowers lock in rates for several years. But monthly debt burdens will eventually rise.

In the meantime, housing prices could drop sharply in some overheated markets like New York and Southern California, where many homes have doubled in price over the last five years. People who bought their homes with no money down could find themselves unable to sell without owing money to their lenders.

Much has changed in the 10 years since the Federal Reserve embarked on its last sustained effort to raise rates. Inflation is much lower today and productivity growth is much higher, which may allow the Fed to take a more gradual approach than it did in 1994.

At the same time, though, many consumers and banks have profoundly changed their attitudes toward borrowing and debt. Responding to lower interest rates last year, homeowners refinanced $140 billion worth of mortgages in which they borrowed additional money. Mortgage lenders, in the meantime, rolled out scores of new kinds of loans, allowing people to borrow far more than they might have contemplated a decade ago.

The new loans go well beyond adjustable-rate mortgages. They include interest-only loans; "no document" loans, which allow people to borrow money at higher rates without proving their income or assets; and "no ratio" loans, which simply ignore a person's monthly income.

Mr. Thompson, who completed the purchase of his townhouse near Denver on Friday, said he would have qualified to borrow $330,000 if he had taken out a traditional fixed-rate mortgage. He qualified for a loan up to $550,000 by taking an adjustable-rate mortgage that will be constant for the first five years and that requires only interest payments.

He also avoided paying mortgage insurance, which could have cost several thousand dollars a year, even though he put no money down -- something that had been mandatory for those who borrowed more than 80 percent of the purchase price. Because of the home equity loan he also signed for, his primary mortgage amounted to only 80 percent of the purchase price.

"People are looking at their payments and asking, 'How much interest rate protection do I really need?'" said Richard Wohl, president of the mortgage banking group at IndyMac Bank, a large lender based in Pasadena, Calif. Nearly two-thirds of IndyMac's new loans in the first three months of this year were adjustable-rate mortgages, and a quarter of all new loans are subject to adjustments in the first year.

Nontraditional loans first proliferated in California and Washington, largely in reaction to soaring real estate prices. But IndyMac and other big Western lenders have been rolling out their full array of options to every part of the country, and competitors in every part of the country have followed suit.

Nationally over the last year, homeowners have tried to lock in low fixed-rate mortgages. But as rates began to creep up in March, making it harder for some people to afford fixed-rate mortgages, home buyers began shifting to the riskier adjustable rates to keep up with high real estate prices.

According to data compiled by the Mortgage Bankers Association, the share of people who took adjustable-rate mortgages jumped to 32 percent in March from about 13 percent last July.

Local mortgage brokers, linked by computer to large lenders and automated loan-approval systems, say they can often find money for almost any kind of customer, sometimes within minutes. . . .

The willingness to take risks is not limited to lower-income families struggling to buy a first home. Even as interest rates appear to be heading upward, a growing number of wealthy homeowners have decided to cut their monthly payments by switching to interest-only loans that adjust as often as once a month.

Alan Bubes, owner of a linen-supply service in Washington, is refinancing a mortgage of more than $1 million on the home he and his wife own in Georgetown. By switching to an interest-only mortgage that adjusts every month, Mr. Bubes expects to cut his monthly payments and reinvest those savings.

"It's a gamble," Mr. Bubes acknowledged, saying that he could make more by reinvesting his savings than paying down his debts. (Edmund L. Andrews, "As Household Debt Rises, New Risk in Higher Rates," New York Times, May 4, 2004, p. C1)

Without waiting for Alan Greenspan, bondholders have already begun to "sell bonds, pushing up interest rates, whatever the Fed says or does": "The yield on the 10-year Treasury note is up one percentage point from the end of March. It hit its 2004 peak of 4.85 percent in mid-May, though it has since retreated a bit, to 4.66 percent. . . . How high will bondholders take yields with the Fed in slow motion? Mr. [James W.] Paulsen [chief investment strategist at Wells Capital Management in Minneapolis] reckons that the 10-year Treasury could rise to 6 percent this year and maybe hit 7 percent later on a wild spike" (Morgensen, May 30, 2004).

Mortgage rates have also risen accordingly:

Freddie Mac reported Thursday that rates on benchmark 30-year, fixed-rate mortgages declined to 6.28 percent, down from 6.32 percent last week, according to the mortgage giant's nationwide survey of rates. This time a year ago, however, rates on 30-year mortgages averaged 5.26 percent.

Rates for 15-year, fixed-rate mortgages fell this week to 5.63 percent, compared with 5.69 percent last week. A year ago, rates on 15-year mortgages averaged 4.66 percent.

For one-year, adjustable-rate mortgages, rates rose to 3.98 percent, from 3.87 percent last week. At this time last year, rates on one-year ARMs were at 3.59 percent. . . .

With the economy moving solidly ahead, economists predict mortgage rates will slowly rise in the coming months. According to some projections, rates on 30-year mortgages could reach 6.4 percent or 6.6 percent by the final quarter of this year.

Still, some economists believe home sales this year will come in close to, or possibly even surpass, the record highs seen in 2003, when ultra-low mortgage rates beckoned to buyers.

The recent rise in mortgages, however, is slowing refinancing activity. Refinancings accounted for just 34.3 percent of total mortgage loan applications filed last week, down from 36.2 percent in the previous week, the Mortgage Bankers Association said. (Jeannine Aversa/The Associated Press, "Rates on 30-Year, 15-Year Mortgages Down," June 3, 2004)

Along with a difficult debate on "whether our volunteer military is adequate to meet our foreign policy commitments" (Andrew Exum, "For Some Soldiers the War Never Ends," New York Times, June 2, 2004), the day of reckoning on the home front seems also postponed until after the November elections. According to the Economist, though, the housing bubbles exist everywhere in the rich industrial nations except Germany and Japan:

House prices have outpaced inflation everywhere in recent years except Germany and Japan, where prices continue to fall. Among our 16 countries, prices are now at record levels in relation to average wages and rents in America, Australia, Britain, Ireland, the Netherlands, New Zealand and Spain. The ratios of prices to incomes exceed their averages in the past 30 years by between 25% and 60%. A return to the long-term average could be brought about either by a fall in house prices or by a rise in wages and rents. The snag is that with wages in most countries increasing by only 3-4% a year, it would take years for inflation to erode real house prices to normal levels.

The chart [titled "Ripe to Burst"] . . . shows by how much prices would need to fall to get back to their long-term average, assuming that the decline takes place over four years and that wages rise at a pace similar to that in the recent past. House prices would need to fall by 10% in America, by 15% in New Zealand and by 20-30% in the other five countries.

Need prices fall so far? Maybe not: lower real interest rates than in the past would justify an increase in the long-term ratio of house prices to wages and rents, and would therefore require a smaller fall in prices. On the other hand, when past housing booms have turned to bust, prices have typically undershot their average by 10% or more. ("Global House Prices: Hair-Raising," June 3, 2004)