Will Adjustable Rate Mortgages Sink Housing Market?

By Jack Kleinhenz
Chair, Regional Utility Roundtable
CEO, Chief Economist
Kleinhenz & Associates

The U.S. Regional Outlook session at the policy conference featured four presentations focused on a “Housing ARM-ageddon? Will adjustable rate mortgages cause the housing apocalypse?”

Moderator Sean Snaith, director, Institute for Economic Competitiveness at the University of Central Florida, “warmed up” the audience with his recipe for a housing soufflé, arguing that the current situation was really not a housing bubble. With the economy preheated from the previous recession, his housing confection included the following ingredients:  77 million baby boomers with home purchasing power, low mortgage rates, innovative mortgage instruments, low unemployment, strong personal income growth, and a pinch of speculative behavior.    His soufflé rose rapidly for several years increasing volume by 2005, but has recently risen slowly or lost a bit of volume.  He expects the soufflé not to collapse unless one of the ingredients is removed or the economy becomes cold.

Jim Diffley, director, U.S. Regional Service, Global Insight, discussed:  “ The bubble(s) have burst so what is next?”  He argued that there were two bubbles in play: rapidly rising prices and an overbuilding.  According to his analysis, the housing crisis precipitated by a rapid rise in prices is more of a bicoastal phenomenon, whereas the overbuilding is taking place in pockets throughout the country.  He reported that as a result of falling home prices the incidence of overvaluation in the nation's housing market continues to decline.  Approximately 60 metropolitan areas remain over-valued and at risk for a price correction, especially in markets along the Atlantic and Pacific Coasts.  For some analysts, Diffley stated there is a concern that because California was ahead of the cycle, it could be an example of what is yet to happen elsewhere.  Diffley countered this argument with evidence that home price appreciation continues to be strong in several areas that came late to the explosion in home prices -- the interior and northern parts of the West, including northern Arizona, Utah, Idaho, Washington, and Oregon.

Brian A. Bethune, director of Financial Economics, Global Insight, talked about the economic outlook with a perspective on how “Micro Stresses Yield Macro Concerns.”  Bethune expects the “drip, drip, drip” of the housing market to be similar to Chinese water torture and will pull down growth in 2007 and some into 2008.   Core inflation is running above 2 percent and is a big risk to both housing activity and prices.   Though the economy is expected to run below its potential, the economy looks in reasonable shape.  Increased overseas demand has kicked in as the slowdown in domestic spending has occurred. Consumers seem reinvigorated by growth in real wages, and they are less concerned by gasoline prices. Business investment is still constructive but with a tepid momentum.  The Federal Reserve is expected to remain steady with current rates though they are mildly restrictive. A rate cut is expected at the August meeting.  The yield curve is expected to remain inverted as long as the economy runs below potential.   There is an 80 percent probability of a soft landing.  The large share of ARMs to be reset in 2007 and 2008 poses considerable potential stress on housing markets and households – micro risks that can give rise to macro concerns.  Bethune argued that the jump in sub-prime mortgage defaults and sharp tightening in mortgage lending standards (AltA & sub-prime) will cause the housing market to continue to struggle.

Keith Schwer, director of the Center for Business and Economic Research, University of Nevada-Las Vegas, focused on the importance of housing being fundamentally a regional dynamic and regions matter. The Plains states are doing well because agriculture is doing well.  Mining in Montana, Idaho, and Wyoming is quite profitable; and, as such, Mountain states are also doing well as commodity prices are up. In the Northwest, high tech seems to have returned as Boeing in particular is showing strength.  In the Southwest, Arizona is an economic engine as population has increased to equal that of Minnesota and Massachusetts combined or nearly 5 million. The housing bubble has hit California, in particular Orange county. He expects that prices will drop further in California markets and also in parts of Nevada.  Yet, the shortfall in housing spending will not derail the economy.  Markets are adjusting and after the burn-off of the excess supply, he expects the economy to recover.