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Adding Fuel to the Fire

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I'd like to expand further on the excellent points Kevin Depew made earlier regarding a "contrarian" WSJ article on real estate. The author, addressing what he calls "Myth #2: Risky mortgage products are fueling house appreciationm" makes the following argument (which appears valid on the surface):

"Why pay several hundred basis points to lock in rates he is highly unlikely to take advantage of? Moreover, very little equity has been paid off by a homeowner in the first seven years of a 30-year loan, so consumers have been effectively overspending on interest rates for generations."

Though this argument makes sense on the surface, things are not that simple. I have to admit, I financed my first condo with an ARM loan some time ago because at the time I felt that long-term interest rates were overextended and an ARM made more financial sense. This is what Greenspan was talking about - evaluating ARMs as a viable alternative since investors often overpay for the predictability of payments that come with a fixed 30-year loan. (Arguably, he made those comments at the worst possible time.)

However, this is not what is going on in today's environment. The majority of homeowners have chosen variable loans (ARM) not from a position of strength (where they evaluated them on their long-term financial merits), but from a position of weakness: homebuyers and especially new homebuyers are "forced" into using different flavors of variable rate mortgages as they cannot afford to own a house financed at a fixed rate. The issue is aggravated further by the surging popularity of negative amortization loans. They work as a double trap as future payments will increase due to higher interest rates (if rates rise) and due to the rising principal amount of the loan. Come to think of it, the popularity of the ARMs and new "revolutionary" products that made houses more "affordable" (in the very short run) has cheapened the cost of money and that was the sole driver of housing prices over the last couple of years. In other words, in the absence of ARMs and financially engineered products, housing prices would have remained at much lower levels.

I was glad to see that article in WSJ as the fact that everybody I know agrees with my assessment of the housing market really worried me. On another hand, homebuilders stocks are doubling every time I turn around, thus there are plenty of housing market optimists out there.

No positions in stocks mentioned.

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