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The Interest Only Mortgage Option

Let’s get this straight.

Household credit is shrinking…
Profits are shrinking…
Employment is shrinking…
Housing values are shrinking…
The wage base is shrinking…

But the recession is over!

Whoa…how is that possible?

This weekend’s news brought no surprises. For example, the housing picture is still depressing – unless you’re a buyer.

There’s “no bottom in sight” to Florida condo prices, says Barron’s. And Reuters warns that option ARM mortgages “are about to explode.” At least, that’s what the attorney general of the sovereign state of Iowa says. The option gives the homeowner the right to pay only the interest (or in some cases less than the interest) for the first few years. They’re sometimes called IO mortgages (interest only). And now these mortgages, written at the height of the bubble, are beginning to reset to more normal terms. According to Reuters, 128,000 people in Arizona alone will face reset IO mortgages next year.

How much more will these people have to pay? Between 5 and 10 times what they’re paying now. Almost all these homeowners are underwater. They bought at the bubbliest period. How many of them can afford a 400% increase in their mortgage payments? How many of them will be willing to pay?

Not many. That’s why a new wave of foreclosures is coming. And that’s why house prices are likely to keep going down; the supply is going to increase, while the demand (willing and able buyers) will probably stay steady.

Meanwhile, the California jobless rate has risen above 12%.

But let’s go back to the first item – shrinking consumer credit. This is the key thing. The expansion of the US economy – broadly speaking – from 1945 to 2007 depended on consumers’ willingness to go further into debt. Wages rose during the first half of that period – supporting consumption. But as the great boom continued, more and more of it was based on credit, not on wages. At the end, it was almost all credit expansion. Consumers weren’t earning more money…nevertheless, they kept spending more and more money. How did they do it? By borrowing.

Without this borrowing the economy would not have grown.

And now what’s happening? Well, consumers aren’t borrowing anymore. Consumer credit is going the other way, shrinking rather than growing.

The feds are trying to counteract this major trend. This year, they’re borrowing $1.7 trillion. Consumers won’t borrow; no problem, the feds will borrow for them!

So far, the feds have put at risk about $13 trillion in order to counteract the downturn. This is about equal to the amount that Americans had lost in the crash. But while the crash wiped out $13 trillion in housing and stock market wealth, the feds have no obvious way to put the money back. Banks were easy to reflate. Bankers and federales are tight with each other; they’re happy to share out the taxpayers’ money. But getting money to the consumer is a different matter. The banks don’t lend and the consumers don’t borrow.

Of the $13 trillion the feds have put at risk…very little has actually made its way to the consumer economy. Result: no new boom in consumer spending…no new boom in hiring…no new boom in production or profits.

Pity the poor investors who are counting on a bull market. Profits aren’t increasing. So the increase in stock prices is based on an increase in the multiple. As stocks rise, investors pay more for each dollar of earnings. Unless there is a big boom coming, this will turn out to be a mistake.

The Dow rose 36 points on Friday. Gold ended the day at $1008. And the dollar keeps sinking; on Friday, American visitors to Europe found that it cost $.147 per euro.

Bill Bonner
for The Daily Reckoning Australia

2 Comments

  1. Joe says:

    I suspect the end of the recession (as in the economy is not shrinking anymore) is a deliberate illusion. The cash injected into the financial system is seeing the net worth in financial billing increase (from a new low point in recent times).
    But, this mountain of cash pumped into the financial system is not filtering through to Joe Public. It is stopping in the financial system and is therefore explaining their growth and the subsequent believe that the recession is ending.
    The problem is, that for everybody outside Wall Street, it isn’t, and won’t do for a long while to come.
    This ‘new’ growth is (in my opinion) only the external expression of the inflation within the U.S economy. Sooner or later Joe (yes that is me) Public will feel its cold shadow.

  2. Robert Landry says:

    “Of the $13 trillion the feds have put at risk…very little has actually made its way to the consumer economy. Result: no new boom in consumer spending…no new boom in hiring…no new boom in production or profits”. All of this I believe is true but Larry Kudlow has said, “Corporate profits are at all-time highs”. Is he confusing earnings with corporations slashing wages and employees? That’s like saying, “I’m healthier because I lost 50 Lbs. Nevermind I had to cut off both legs and one arm”.

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