Wednesday, December 15, 2010

The Perils of Interest-Only Morgages

A quick follow up to my previous post. Via The Economist, the Federal Reserve Bank of Chicago has an interesting new paper suggesting that interest-only mortgages were the key means through which participants in US housing markets speculated on rising prices. Do not attempt to read the whole thing unless you are a total masochist; it's very dense and full of equations. But here's a bit from the abstract:
We describe a rational expectations model in which speculative bubbles in house prices can emerge. Within this model both speculators and their lenders use interest-only mortgages (IOs) rather than traditional mortgages when there is a bubble. Absent a bubble, there is no tendency for IOs to be used. These insights are used to assess the extent to which house prices in US cities were driven by speculative bubbles over the period 2000-2008.
We find that IOs were used sparingly in cities where elastic housing supply precludes speculation from arising. In cities with inelastic supply, where speculation is possible, there was heavy use of IOs, but only in cities that had boom-bust cycles. Peak IO usage predicts rapid appreciations that cannot be explained by standard correlates and this variable is more robustly correlated with rapid appreciations than other mortgage characteristics, including sub-prime, securitization and leverage.
So what does this mean in simple English? Essentially the researchers are saying that the prevalence of interest-only mortgages is THE key predictor of rapid price appreciation in housing markets, and is fact is an even stronger predictor than other factors such as the amount of subprime loans or measures of leverage such as LVRs. 

Needless to say, this is a pretty interesting result in light of the popularity of this type of loan in Australia. Again, here's the chart from Westpac that I displayed in my last post:

Source: Westpac

As you can see, around 30% of owner occupier and 50% of investor loans in Australia are interest only. If this isn't evidence of a speculative bubble, I'm not sure what is...

More from the paper on interest only loans:
Lenders prefer these contracts because they preclude the borrowers from gambling at their expense for too long, given that speculators will be forced to sell the asset once payments rise (or else refinance with another borrower if possible). At the same time, borrowers prefer these contracts because they can defer building up equity in what they know is a risky asset, leaving them with the option to default on all of the principal they borrowed should the prices collapse early. 
As I said in my last post, this is essentially a giant ponzi scheme, where borrowers are relying on the notion that prices can only go up, and that when the loan resets, they will easily be able to refinance. Not surprisingly, the researchers at the Chicago Fed found that the prevalence of interest-only loans was not only highly correlated with big price volatility on the way up, it was also correlated with volatility on the way down when prices started to decline and everything went pear shaped.
So far, our results show that the use of IOs appears to be strongly associated with rapid house price appreciation before house prices peak. However, the model would suggest that the use of these mortgages would also be associated with rapid declines in house prices if and when house prices collapse... we find a similarly strong correlation between the share of IOs and the decline in house prices following the peak to the one we found for house price appreciation. 

As The Economist says:
...the question for the peanut gallery is this: if IO mortgages are most commonly associated with bubble markets, and correlated with rapid price increases, are a means to bet on the continuation of those increases, and are therefore more likely to end in default, should they be allowed? Should users of interest-only loans be able to receive the same homeowner subsidies as other kinds of borrowers (assuming the subsidies aren't scrapped entirely, as they should be)?
Hear hear.

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