Pop Goes The Bubble?

The kind folks at Battery Ventures wrote an excellent article on Alan Greenspan’s legacy, which also discussed a subject near and dear to my heart, to wit, the housing bubble.

Take these two statistics, for example, drawn from an LA Times article:

“In 2001, as the current housing boom got underway, fewer than 2% of California homes were bought with interest-only loans, according to an analysis done for The Times by LoanPerformance, a San Francisco mortgage research firm.

By last year, the level had risen to 48%. Nationally, LoanPerformance says, interest-only loans were used in about a third of all purchases.”

Okay, so people are diving into interest-only loans. What’s the big deal? Well, while the borrower may be able to afford the payments now, when the principal starts to come due (generally after 3 years), the required payments jump.

Now add in this fact:

“In California, the traditional fixed-rate loan is in danger of becoming extinct. According to recent LoanPerformance data, the percentage of new loans that are adjustable in Santa Cruz and San Diego was 85%; in Oakland 84%; in Santa Rosa 81%; in Los Angeles 74%.”

So in all likelihood, close to half of new mortgages are of the interest-only, adjustable-rate variety. This might be fine if the folks taking out these loans left themselves plenty of financial cushion, but the whole point of interest-only and ARMs is to let people “stretch” to buy houses that are more expensive than they could otherwise afford.

So what happens in a couple of years, when the weakening dollar leads to a rise in inflation, which triggers a rise in interest rates, which bumps up the payments on ARMs, just as the principal on those interest-only mortgages comes due?

Pop.