Chocolate and Gold Coins

Sunday, May 29, 2005

Gambling on Real Estate

The WaPo had an article in yesterday’s paper about interest-only home loans:

More than a third of the mortgages written in the Washington area this year are a risky new kind of loan that lets borrowers pay back only the interest, delaying for years repayment of any loan principal. Economists warn that the new loans are essentially a gamble that home prices will continue to rise at a brisk pace, allowing the borrower to either sell the home at a profit or refinance before the principal payments come due.

The loans are attractive because their initial monthly payments are tantalizingly low -- about $1,367 a month for a $320,000 mortgage, compared with about $1,842 a month for a traditional 30-year, fixed-rate loan. If home prices fall, though, borrowers could lose big.

These loans have really caught on in the last five years. The article says that five years ago these loans only represented two percent of the metro D.C. market; now it’s more like one-third.

These loans make it possible for people to afford more expensive homes. If there are no more homes in the inner suburbs, then the net effect of these new loans is to drive demand to the right and the price of homes straight up. That’s good for people like me who already owned a home but it means that there is much more risk of a sudden housing market collapse.

These new loans mean more leverage. More leverage means a greater probability that a relatively small decline in housing prices will wipe out the homeowners’ savings and force them into bankruptcy. A large number of bankruptcies coupled with a large loss in homeowner equity would probably mean a big recession.

Is this 1929 again?

I have to wonder if the government should regulate the amount of risk people take. We outlaw gambling in most states. Other forms of speculation are like gambling. If one person gambles and loses, it’s his own problem. If one hundred million people gamble and lose it’s everybody’s problem. This is a fundamental problem of moral hazard. Society needs to make sure that others are not going to shift their risk onto society’s shoulders.

Maybe these new interest-only loans are just too risky for society.

4 Comments:

  • "I have to wonder if the government should regulate the amount of risk people take."

    Lenders are supposed to do this themselves by evaluating the applicants' creditworthiness.

    If lenders had any common sense these days, they'd raise the downpayment requirements because of the likelihood of a real estate downturn.

    By Anonymous Half Sigma, at 9:13 PM  

  • Hi Half Sigma
    I would agree accept that the lenders have a fairly serious moral hazard problem. The biggest lender are these quasi-government organisations Freddie Mac and Freddie Mae. They know that if the market goes south and everyone goes bankrupt at the same time, the government will bail them out.

    I think this is the problem with letting lots of people gamble on the same event. It's heads we win and tails you lose.

    By Blogger Michael Higgins, at 6:37 AM  

  • I agree.

    By Anonymous Half Sigma, at 11:07 AM  

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