Housing: Even More Red Flags

Particularly worrisome is the surge in cash-out mortgage refinancings

The Commerce Dept. on Aug. 2 reported that consumer spending surged a robust 0.8% in June, even as the personal savings rate dropped to zero. Thankfully, that's not quite as scary as it sounds: The peculiar methodology government bean-counters use to measure new car sales and capital gains sometimes undercounts the rate. But that zero savings figure does suggest just how dependent U.S. consumers have become on a single source to fund their purchasing power: the American home. Forget all that Depression-era prattle about deprivation and sacrifice. Why bother to save when you're living in a piggy bank?

If all this sounds a bit too good to be true, it probably is. History tells us that we can never be certain of the existence of bubbles until after they pop. But the current U.S. housing frenzy is certainly starting to pass the smell test, at least in certain markets. Existing home prices have skyrocketed 29% since 2003, with white-hot markets like Las Vegas and San Diego seeing even greater gains. According to a survey by the National Association of Realtors, last year 23% of homes were bought as investments and an additional 13% as vacation homes. That means more than a third of homes that changed hands in 2004 were not primary residences. Many of those buyers are no doubt riding a horse called price appreciation, and so far they have been richly rewarded -- or simply lucky.

More worrisome, there is growing evidence that even owners of primary residences are raising their bets by increasing their leverage. A new report by mortgage giant Freddie Mac (FRE ) shows a continuing surge in so-called cash-out mortgage refinancings, where a homeowner pockets cash while increasing the size of his mortgage principal. For instance, 74% of Freddie Mac-owned loans that were refinanced in the second quarter resulted in new mortgages with loan amounts that were at least 5% higher than the original mortgage balances, the highest such share since early 2000. In contrast, only 9% of Freddie's refinancings resulted in lower loan amounts. In other words, the current borrower strategy is to take the money and run.

Real estate's current spate of "irrational exuberance" is fine as long as personal income growth holds up, loan-to-value ratios don't increase, and financial institutions are careful to hand off risky loans and mortgage securities (which could quickly drop in value if cash-strapped owners start to default on their loans) to other investors. But that's a lot of ifs -- especially at a time when fee-hungry lenders seem fixated on near-term profits and the lure of cheap money actually penalizes people for being too cautious.

All these are among the reasons why Fed Chairman Alan Greenspan has been warning for months of froth in the housing market and why the Fed has begun reminding banks to be sure they're adequately checking credit when making all these loans. So far, Greenspan's warnings have been to no avail, refinancing-fueled consumer spending continues apace, and housing speculation remains favored cocktail party chatter from Manhattan to Monterey. That's why it's time for buyers to ask if they really intend to live in a home for the five, ten, or even thirty years they are financing it. If not, they would be wise to leave the speculation to the commodity traders. Unfortunately, a sure thing often becomes a sucker bet.

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