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The Good News and the Bad News About Interest Rates

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May 20, 2005

The Good News and the Bad News About Interest Rates

Amey Stone

This week investors rejoiced that, thanks to low inflation numbers, it looks like the Federal Reserve won't keep hiking rates as long and as sharply as feared. That's the good news.

The bad news is that interest rates are now likely to stay low enough to fuel housing and consumer debt bubbles. My current view is that the housing market is entering a new level of over-headedness. This is the throw-in-the-towel time when all the naysayers decide that the optimists must have been right and the housing market really will keep booming into the foreseeable future. For Internet stocks, it would be circa November, 1999.

Greenspan tried to jawbone the real estate market lower this week by voicing his concerns. But he doesn't have the same sway over homebuyers that he has over investors.

Merrill Lynch's mortgage finance analysts warned in a report today:

Recent headlines and news article continue to focus investor attention on the potential for consumer credit to deteriorate given what is perceived to be an unsustainable amount of leverage of the consumer balance sheet, use of adjustable rate financing in a rising rate environment and an over-inflated housing market fueled at least partially by the use of creative financing.

In a section warning investors to avoid investing in non-prime mortgage companies, the Merrill analysts write:

If housing values fall meaningfully and credit deteriorates simultaneously, which we think is plausible, then we believe the sector could face liquidity issues, causing significant volatility in the shares of companies heavily leveraged to this sector.

08:52 AM

Real Estate

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I think that as long as mortgage rates stay low, the housing market will keep going gangbusters. The rate on a convential 30-year mortgage is still under 6% (actually, 5.9%), and adjustable-rate loans are even lower. What could be fueling the market now is the rush to buy a home before rates go even higher.

Posted by: Karyn McCormack at May 20, 2005 06:40 PM

What Greenspan is trying to (too late) is preparing for the day when bursting of US housing bubble causes lot of pain. Then he can come out and say its not central bank's fault. He didn't raise margin rates when NASDAQ bubble was in full swing. As the head of banking system in the US it is absoulutely careless of Greenspan not to say anything about interest only loans. There was article in May 20th, San Francisco Chronicle that mentioned in last six months 2 out of 3 houses in SF bay area have been bought using interest only loan. Does this not sound like a mania?

Posted by: Sam Jones at May 23, 2005 12:59 AM

The other way to look at interest only loan is a tax -deductible rent. Sounds odd, but in several markets you can still own a bigger house than one's currently rented one at the same mortgage interest as the rent. It is partly speculative but if one can stay put in that home for atleast say for 5 years then it may work out in one's favour. Nonetheless it is still speculative and the normal risk-reward profiles apply.

Posted by: Dhaval Shah at May 24, 2005 01:49 PM

Good thoughts but your timing is way off. People started talking about the bubble in internet stocks in 1996. Greenspan spoke of irrational exuberence in 1997. There was a dip in 1998 and then the last strong surge in 1999. Current demand is more about second homes than first homes and most folks have not purchased a second home yet. The housing boom has many more months to go and the bubbles are only in selected high demand cities and resort communities.

Posted by: Jack K. Miller at June 7, 2005 01:08 AM

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