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"Exotic Mortgages" and The "Housing Bubble":

There has been much criticism lately about so-called "exotic mortgages" that are creating a "housing bubble" ((expressed by David, among others).

Although often lumped together, the two are distinct. And I'm not sure I see what the problem is here. I want to focus on the supposed harm of exotic mortgages, especially interest-only mortgages (which are said to create the housing bubble by allowing people to borrow "too much" and forcing up home prices).

The concern, as I understand it, is that people who have interest-only loans (for instance) are going to be hurt if home prices fall (although it is not clear why they would, if everyone is adopting the new mortgages--but I digress). The idea is that if housing prices fall, and if they have to sell their house, they will be forced to come up with a big wad of cash to make up for the shortfall. And so these exotic mortgages are said to be "bad." Now here's what I don't get:

Households have three basic sources of capital--human capital, financial capital (stocks and other financial investments), and their homes. For obvious reasons, there is a very high correlation between and individual's human capital and their home values--local real estate markets are tied very closely to local economic conditions (i.e., salaries/human capital). So, for instance, a few years ago, Boston simultaneously suffered a downturn in its high-tech sector, leading to layoffs and pay cuts, while naturally also reducing housing prices. Thus, Bostonians simultaneously suffered dramatic reductions in both the value of their human capital and residential real estate investments.

So, the correct strategy to minimize one's mortgage payment (such as by paying only interest and not making the additional principal payment?) and to instead invest the difference in a diversified financial portfolio of stocks or other financial assets that are not so closely tied to the local economy. It seems to me that it is not correct to pay down the principal on one's mortgage, which would increase the covariance of your human wealth with your home equity. In fact, it is likely that one of the reasons why housing prices have been rising is because the moribund stock market seems to be inducing some people to remove their assets from the stock market and to put them into residential real estate.

Moreover, money paid in as principal on your house (such as a downpayment) is dead capital--and the only way to get it back out to invest is to take out a home equity loan, which usually has a higher interest rate than it would be if you were just paying interest in the get go and using the saved principal payments for other purposes. So because of the time value of money, you are getting poorer when you pay down principal on your loan that does nothing for you, because you aren't getting any interest on this money. And this doesn't even take into account the "home equity trap" that may mean that you can't get approved for a home equity loan when you most need it, such as when you become unemployed.

And the primary wealth accumulation component of a house is the speculation appreciation in value, not the paid-down equity. Thus, that paid-down equity will do little to hedge against the upside or downside risk of property value fluctuations. So it seems to me that we want to encourage individuals to minimize their principal payments on their houses and instead to diversify that money into financial assets that will diversity away from the risk associated with human capital. In other words, rather than encouraging people to make worthless principal payments on their mortgages that do nothing for them, we would be better off encouraging them to invest in financial assets, and if their houses actually fall in value, then they can tap these savings if they need to make up the difference.

So the question of what happens if housing prices fall (or interest rates rise) is only half the question. The other half is what happens if housing prices don't fall that much, or interest rates don't rise that much? In that case, all of those who earned effective negative rates of return on piled-up principle payments on their home mortgages will be the ones who are worse off in an opportunity cost sense as compared to those who invested those funds. Obviously there is a risk issue here either way, as there always is. For instance, just a year or two ago Alan Greenspan was noting that Americans who had entered into 30-year fixed mortgages had paid millions of dollars in higher interest fees than they would have paid had they held variable-rate mortgages that would have allowed them to ride the interest rate market down.

So, it seems to me, rather than hand-wringing about exotic mortgages and housing bubbles in isolation, the relevant question is whether people have properly diversified their wealth holdings in case the housing bubble does burst and in case a fall in housing prices is offset by a rise in the price of financial assets. On that issue, I have seen little intelligent analysis recently.

Update:

Interesting and extended comment on my post at Shivering Timbers, which for some reason the Trackbacks didn't pick up. I commend the entire long version of the post, but here's a summary he sent me:

In summary, I think there are two flaws in your analysis.

First, most people don't think in terms of risk as "deviation of expected return" but rather the odds that an unforeseen event will have a negative impact on their lifestyle. Exotic mortgages (and any other strategy to increase the leverage of one's home) increase this lifestyle risk by increasing the odds that some negative event (job loss, etc.) might cause a forced-sale situation. Most people would consider losing their home a much more negative event than an unrealized decrease in the value of the home.

Second, even though exotic mortgages can be used for good or bad (just like any tool), your analysis supposes that people are using them as part of a well-considered asset diversification strategy. While I'm not aware of any data specifically addressing this point, everything I've seen (such as the dramatic increase in the percent of homes bought purely for investment) suggests that this tool is in practice being used to buy more home(s) than people could otherwise afford, in the hope of future asset appreciation. In other words, the leverage is being employed to increase asset concentration, not decrease it. This is classic bubble behavior.

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