Balloon or bubble?

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Over the weekend, Federal Reserve Chairman Alan Greenspan warned housing boom speculators should be very careful. What goes up fast can come down just as fast.

A key underpinning of the housing price surge is the lenders' belief risks have fallen. They therefore became more willing to lend on terms they would not have extended in the past. This made available mortgages to previously unqualified borrowers and bigger mortgages to those with good credit.

A new report from SMR Research found, in the first half of this year, 38.1 percent of homebuyers financed more than 95 percent of their purchase. In other words, they bought with less than 5 percent down. The percentage doing so increased from 34.1 percent last year and 30.6 percent in 2000.

The same report found 66.3 percent of homes bought in 2005 involved borrowing more than 80 percent of the value, up from 60.9 percent in 2000. Historically, loans with less than 20 percent equity have been considered risky.

An important reason for the increasing loan-to-value ratio is the proliferation of "piggyback" loans. Basically, a borrower takes out two mortgages simultaneously -- a first mortgage and a second, piggyback mortgage on top.

The first mortgage will be "conforming," meaning it is resold easily on the secondary market. The balance might be in a home equity loan or credit line used to make the initial purchase, rather than taken out after.

Breaking the total mortgage into two parts allows people to borrow more money with lower incomes than if they had a single "jumbo" loan, as in the past. According to a recent report from PMI, a mortgage insurance company, in many hot housing markets 60 percent of home sales are financed with piggyback loans. The size of piggyback loans is also increasing rapidly, from $37,757 in 2001 to $51,617 in 2004.

Such loans are riskier than traditional loans because there is less equity backing the loan, making lenders more vulnerable to loss in an economic downturn or falloff in home prices.

Further adding to the risk of default is the proliferation of interest-only loans. Historically, mortgage payments included a payment of principal that reduced the outstanding loan amount. In 2004, a third of new home sales were financed with mortgages having no payment of principal, according to LoanPerformance. As with piggyback loans, interest-only loans allow people to borrow more and buy more expensive housing, but with less of a margin to protect lenders from default.

Although they benefit enormously from such financial products, the National Association of Realtors recently warned about their proliferation. It has published a pamphlet noting some types of mortgages may have low "teaser" rates that escalate rapidly and may automatically add to one's mortgage. Other mortgages' payments rise automatically as interest rates rise, which could price some people out of their own homes.

The Realtors' warning is admirable, but it's hard to believe very many real estate agents will go out of their way to warn potential buyers against exotic mortgages if it costs them a sale. So it's really up to homebuyers to be careful about overextending themselves in a market unlikely to keep rising.

As Mr. Greenspan warned Saturday, "the housing boom will inevitably simmer down" and "prices could even decrease." Even with no increase in defaults, the housing price leveling will have a major effect on the economy, he said. Refinancings have allowed homeowners to tap growing equity to finance consumption, which explains America's zero savings rate.

Mr. Greenspan noted the nation's current account deficit, which measures the importation of foreign saving, and the extraction of home equity are closely correlated. If home prices flatten or fall, people will have to save more and consume less. That will reduce the current account deficit but slow economic growth.

Though he is no alarmist, Mr. Greenspan warned Friday that if lenders should perceive greater risk, rates could rise and borrowing qualifications tighten quickly. "Newly abundant liquidity can readily disappear," he noted.

Access to mortgages will become much more limited, people will have less money to pay for housing, and this must bring prices down. A mild downturn could thereby become a collapse, with consequences throughout the economy.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.