Cycles

It seems to me that people have a tough time digesting the concept of cycles. I love this quote from Shakespeare’s Julius Caesar.

There is a tide in the affairs of men
Which taken at the flood, leads on to fortune.

There is also a time when the tide ebbs, and that path leads on to misery. A fact of the world is that the tide comes in and the tide goes out. When things are good, people assume that they are going to stay good forever. When times are bad, they assume that they will never get any better.

When you look back at history, even the last couple of decades, it is obvious that the stock market has gone up and down, interest rates have gone up and down, and housing values have mostly gone up but there have been periods when they have gone down too.

One reason for cycles is that when times are good businesses keep spending money and expanding when they should start being more conservative. For example, in the late 1980 the banks and developers seemed to think that the expansion of commercial building could go on forever. They kept throwing money at projects. Hotels, shopping centers, office buildings and the like were being built at increasing rates although when they were finished, no one was there to occupy them. This was one of the factors that lead to the severe and protracted real estate recession of the early 1990’s.

When the “good” part of a cycle starts, as in housing, the first thing that happens is the satisfying of demand that was pent up during the last bad time. In the middle part of the cycle the demand is the normal creation of new households. In the last part of the cycle we start borrowing from the future. I believe that is what has happened and is happening now.

Now we all know that with low interest rates, a lot of new homeowners were now able to afford homes. There are certainly those who have been granted a wonderful opportunity to fulfill their dreams. I, for one, am happy about expanding the opportunities for home ownership. And we still have 33 percent of the American public that doesn’t own a home, so there are still some potential buyers out there.

What has not been quite as obvious is that this normal growth has been combined with significant loosening of mortgage credit standards. As a result, people who never would have been able to buy a home under the old underwriting criteria suddenly find themselves homeowners.

When you look at the statistics nationally, you can see that there has been an explosion in mortgages that wouldn’t be classified as “A-paper.” First are the “sub-prime” mortgage borrowers, those with a poor credit history. Second are the “non-traditional” mortgages, where people are making no down payment. These two groups make up over 40 percent of mortgages being originated today.

I’m reminded of the old Johnny Carson car salesman character, “No down payment? We don’t care! Poor credit? We don’t care! Can’t prove your income? We don’t care! Can’t make your payment? Then we care!”

Where does this lead? Bluntly, we have some people who are not worthy of home ownership and we probably made it possible for a lot of them to buy too. We may have not been doing them a favor. I think the world is getting better, but perhaps I don’t see the cycle very well.

What happens when the adjustable mortgages come off of their 1.95% teaser rates and the payment goes up? What happens when people who have no reserves lose a job? What happens if the market dries up and they have to sell and there is no equity and no buyers. What happens if values plateau or drop? What happens to the supply of mortgage money when some of these lenders start getting burned?

Bottom line, there will be some hurting people out there. In my view it is a time for caution and a time for prudent decision-making.

Be careful out there.