REAL ESTATE BUBBLE? VOL 2

In response to many angry emails regarding my Real Estate bubble post, I'll spell out the "exotic" financing method fueling a lot of the current real estate boom. I mentioned the term "exotic financing" and likend it to the "exotic" woman across the room who you just know is too dam good for you, and who would dump you in a second if someone else came along.....but this voice inside you screams at you, if only you could fuck her just one time. You do and she does.

Interest only loans. The exotic woman across the room. You fall in love before you say "hello." Are you fucking crazy? If you only pay interest you are paying rent. You don't own your home. You will only own that portion of the home that accounts for the difference in the price paid and the new valuation later IF real estate values rise. The bank is gambling that your home value will continue to soar. So are you.

How pervasive are these "loans?" San Luis Obispo Tribune:

Interest-only loans financed nearly 70 percent of the home purchases in San Francisco, Marin and San Mateo counties during the first two months of this year....

The statistics were similar in San Jose, where interest-only loans accounted for 61 percent of home mortgages in January and February, up from 9 percent three years ago

Why are people doing this? Because they can't afford a house any other way. Housing prices are too high. So you go for the exotic "deal." You can't afford to buy. Everybody is speculating. But what's exotic about that? I understand that.

Exotic #1: Pile atop the interest only loan the term "adjustable rate." This means if rates rise, so do your interest only payments. Your payments could rise to the point where you have to sell your house. But it isn't yours. So.....

Exotic #1A: Not only can the interest only payment rise, but at some point---usually within a few years---you are going to have to start making payments on the principal. Those payments can drive you out of your home and into bankruptcy.

So here's the "deal" you grab. You buy a home that would cost you $1,200 per month at current rates of 3.5% BUT there is a "deal" out there that allows you to pay interest only. Since you are paying interest only, and the interest on this "deal" is only 5.5%. You are making payments of only $700 per month instead of nearly $1,200 per.

"But wait a minute," you say, "Isn't 5.5% higher than 3.5%?"
"It only seems that way to the unsophisticated," oozes Larry the Lender. "5.5% over five years of interest only, results in lower payments. How do you think Bill Gates got to where he is? Just sign it."

BUT, once the introductory period ends your payments will jump to $1,900 per month (see below). Guess where you'll be living then unless you have sold at a profit?

Exotic#1B: There is virtually no interest rate cap on the "adjustable." It can top out at 19%.

Exotic#1C: Once you have to begin repaying the principal you are actually refinancing your loan back to a standard 30-year mortgage. Translation: you are taking out a brand new loan. But in addition to paying closing costs on the new loan, you also must pay a $4,500 prepayment penalty to get out of the old one.

So, just like Long Term Capital Management and some of the other "exotic" hedge funds of a few years ago, there is more than meets the eye; there are also things very sophisticated that seemingly have nothing to do with your loan.

But they do.

Exotic #1D: All home loans are repackaged (securitized) and then sold in the bond market in a package with 50 or 100 other home loans. The bank attempts to avoid the risk in the loan by selling the loans to someone else and making a quick profit. They will use that profit to loan more money. These bonds are quoted each Saturday in Barron's. They are known as MBRs) There are also REITS, REMICS, and a fucking ton of "derivitives."¹

BUT when a home loan that has been placed in a bond portfolio becomes "non performing" that loan must be replaced with another loan that is performing.

If there are too many home loan defaults the bank will not have performing loans to replace the non performers. This means a collapse of the bond market. Overnight you would see interest rates rise exponentially. Everyone in these "interest only" loans will see their payments go through the roof.

It is a serious problem in some places in this country. That's why Greenspan is worried, he recognizes that we are building an economy based on high risk debt. Can't last folks. Can't last.

¹ To see a Goldman Sachs example of securitized home loans go HERE