Neg Am Mortgages

Yale economist Robert
Peter Coy

Yale economist Robert "Irrational Exuberance" Shiller thinks the U.S. housing market is forming a giant, soapy bubble that's going to pop.

It might seem strange, then, that Shiller said nice things in his last book about "negative amortization" loans. With a neg am loan, you don't pay all the interest you owe each month. Unpaid interest gets rolled into the principal owed, which goes up and up.

So why does Mr. Irrational Exuberance like neg am loans? Interesting question.

First of all, let's be clear--Shiller isn't moonlighting as a mortgage broker who gets people over their heads in debt.

The positive reference to neg am mortgages appears in Shiller's 2003 book, The New Financial Order: Risk in the 21st Century. (Pages 209-210.)

He's talking about the early 1980s, when inflation was raging and rates on 30-year fixed mortgages briefly got as high as 20%. (Yow!)

That was a different world. With such high mortgage rates, many people simply couldn't afford to buy homes. Sure, the fixed monthly payment would look cheaper and cheaper as the years went by because of high inflation. But in the beginning, before inflation had a chance to do its wonders, the payments were simply prohibitive.

That's where neg am fixed-rate loans came in. Your monthly payments, instead of being flat, would go up year by year. Not a bad idea: the cost to you would remain roughly the same in real dollars over the life of the loan instead of going from chokingly high to ridiculously low. Houses became affordable.

The catch, of course, was that borrowers didn't pay all the interest they owed in the early years. The unpaid interest got added to the principal. But later, as payments rose (in line with inflation), all the principal would eventually get paid off on schedule.

All in all, a neg am loan with a fixed interest rate was a sensible product at a time of extremely high inflation and interest rates.

Unfortunately, the new neg am loans are a very different and more dangerous breed. Most of them are in the form of "option ARMs," where borrowers choose each month how much they want to pay. The minimum payment is the one that can lead to negative amortization (i.e., where the amount you owe keeps going up).

There are two big differences from the early 1980s:

--Inflation and mortgages rates are lower, wiping out the main rationale for neg am loans. (Payments don't have to start out extremely high when inflation is low.)
--Most of the neg am loans have adjustable rather than fixed rates, so negative amortization can pile up more quickly. They're set up so when the loan's index rate goes up, the payment goes up less or later. The difference is piled onto the principal due.

Of course, just because you have an option ARM doesn't mean you have to make the minimum payment. But that's exactly what most people are doing, says David Liu, director of the mortgage strategy group at UBS.

Why? Maybe because it's human nature to pay as little as you can and hope tomorrow will take care of itself. Or maybe because some people bought houses that they couldn't afford and simply can't amortize the principal on their loans.

I sent Robert Shiller an email today asking him what he thinks about the new generation of option ARMs. I'll let you know what he says.

Before it's here, it's on the Bloomberg Terminal.