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"In Arm's Way: The Tender Trap of Adjustable Rate Mortgages."

Our weekly commentaries provide Euro Pacific Capital's latest thinking on developments in the global marketplace. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital.
Peter Schiff
Friday, May 7, 2004

Contrary to popular rhetoric, given today's interest rate environment there are no circumstances for which homebuyers should choose adjustable rate mortgages (ARM's). That so many are currently opting for ARM’s 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 to appropriate levels, the more homeowners that will be lured into the ARM time bomb.

One argument is that by using ARM's, "savvy" homeowners save money because even when interest rates ultimately rise, the months of lower payments will more than offset the extra months when the payments are higher. This ignores the fact that when those higher payments ultimately arrive most borrowers may not be able to afford to make 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, to be drawn upon to meet future increases in ARM payments. The typical borrower is already maxed out with the current low payment, and hopes to meet any higher future payments by extracting appreciated equity.

The most popular justification for choosing an ARM (other then the fact that many borrowers simply can 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 follows that if buyers will be selling their houses in 2-3 years, 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 in 2-3 years is itself one of the best signs of the speculative nature of the current real estate market, for those doing so are speculating on price appreciation, plain and simple. Without such an expectation, 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 necessities, individuals buying and selling houses in 2-3 years (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 planning on selling their houses in 2-3 not use ARM's, they should not even be taking out mortgages at all— they should be renting! That is unless they are speculating that the property will appreciate to a degree higher than all of those costs.

Short term buyers could have only two possible plans; sell and rent, or sell and buy another house. The only reason to buy a house, with the ultimate intention of selling in a year or two to become a renter, is to speculate on price appreciation. However, if you listen to real estate brokers, most are planning to sell current purchases in 2 -3 so that they can trade-up for houses more expensive 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" homes. In other words, in these situations, buyers are also speculating on price appreciation.

Assuming today's short-term buyers put their houses on the market 2 -3 years from now, to whom will they sell, especially if interest rates have risen sharply? If the current crop of buyers relied on low interest ARM's and lax lending standards to qualify for their mortgages, how will future similarly situated buyers qualify with higher interest rates and stricter lending standards? And if the current short-term buyers can not sell their houses, how will they afford to move? Even if they could sell, how would they be able to afford the increased payments on more expensive houses in a much higher interest rate environment? Therefore, short-term buyers may very well end up living in their houses for much longer periods of time then was their intention, unless of course, as will be the case for most, they lose their houses in foreclosure, in which case they become renters.

Buying a house used to represent a long-term commitment to paying off a mortgage, a place to raise children and to grow old. This concept is completely lost in today's world of short term ARM's and interest-only mortgages, which defeats equity accumulation, traditionally the main advantage of homeownership. Real equity is accumulated by paying down a mortgage. However, in today's real estate bubble, principle payments are rarely made, and homeowner are convinced that equity accumulates though price appreciation alone. In the perverse world of "starter homes" and "trading up," homebuyers accumulate greater and greater amounts of debt. Instead of reaching retirement age with fully paid for homes, a situation often critical to making retirement possible, today's homeowners will be in debt up to their eyeballs. Sure, they will supposedly have all this equity accumulated from price appreciation (assuming it hasn't been tapped into through cash-out refi's) but will that equity really exist when homeowners need to sell?

Those who argue that real estate is not a bubble typically have a vested interest in perpetuating it. 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, and whose judgments have therefore been clouded by their own greed. 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, the fact that so much of the "equity" accumulated during the bubble has already been cashed out, and 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 American savers, who's retirement dreams will vanish in a cloud of hyper-inflation. 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 it will have been squandered to perpetuate the biggest real estate and consumer debt bubbles of all time.