Mortgages must amortize to prevent housing bubbles

If Dodd-Frank were repealed as Republicans want, the end result would likely be another housing bubble.

Financing terms largely determine the equilibrium price for housing. Short term fluctuations in supply and demand cause gyrations, but over time the amount potential buyers can borrow will determine what houses cost. For example, the reason prices are going straight up right now is because potential buyers can borrow large sums due to very low interest rates. The activities of these buyers coupled with a depleted MLS inventory is causing prices to rise. Prices will continue to rise until potential buyers reach the limits of their borrowing power or new supply comes to the market. Banks are intent on the former outcome.

House prices rely on four things:

  • Interest Rates
  • Borrower Income
  • Allowable-Debt-to-Income Ratios
  • Amortization

The type of loan program matters. Amortizing loans make for the smallest loan balances because a portion of the payment goes toward paying down principal. If the loan does not amortize, the entire payment can go toward interest, and the loan balance can be much larger. At its ultimate extreme, if the loan negatively amortizes (the balance gets bigger rather than smaller), and lenders use teaser rates, truly prodigious loan balances can be underwritten on very small payments. Buyers on the margins using these methods inflated the Great Housing Bubble.

Many of my cartoons are just for fun, but there is often a serious point behind them. The cartoon about housing market drag racing below illustrates the credit cycle that inflates housing bubbles.

In a “normal” market, prices are determined by the interaction of interest rates, borrower income, and debt-to-income ratios applied to a 30-year fixed-rate amortizing mortgage. In normal markets, the friction that limits the number of transactions is generally affordability. Needing to borrow more money to get their dream homes, desperate borrowers sometimes respond by financing with adjustable-rate mortgages. The first sign of an overheating market is an increase in ARMs.

ARMs generally carry a lower initial interest rate than fixed-rate mortgages because the lender is passing the interest rate risk to the borrower. Many people over the last 30 years of declining interest rates have come to believe ARMs are a safe loan product that can save them money and allow them to buy a bigger house. In the rising interest rate environment likely to be with us for the next 30 years, people who finance with ARMs will get burned.

The same forces that compel people to use ARMs further compel them to abandon amortization altogether. There is a slow but inexorable migration from amortizing ARMs to interest-only ARMs and finally to negatively amortizing loans. Unfortunately, interest-only and negatively amortizing loans are Ponzi loans, and once they proliferate, it’s like an iron core of a large star leading to a supernova. The market implodes.

Fortunately, both interest-only and negatively amortizing loans were banned by the new regulations.