Sunday, October 24, 2004

Will the Market Stay Strong, Or Will It Fold?


Published: October 24, 2004, Sunday
New York Times

PRICES of apartments fall 10, 20, 30 percent. Houses languish on the market for months, or even years, as desperate sellers slash their asking prices. Mortgage financing dries up, sucking even more money out of the housing market.

Is this the dire fear-mongering of some bubble-bursting Cassandra, predicting the coming real estate crash? Not at all. Those who were around to witness it will recognize this as a description of the New York real estate market just 15 years ago, when another real estate boom that many thought would never end came tumbling to earth.

Could it happen here again?

''The market has never been better, that I remember it; that's the good news,'' said the developer Donald J. Trump. ''It's also very dependent on interest rates. If they do go up, the market will truly tank.''

Mr. Trump predicted that an increase in mortgage rates of three to four percentage points over the next two years -- a figure not out of line with some economists' predictions -- could have a strong adverse effect. But he added a caveat: ''I just don't think that the politicians can allow the rates to go up because then the economy beyond real estate will tank.''

The boom and bust of the 1980's and early 1990's was created by a confluence of factors. Changes in the tax code spurred a speculative building boom in New York, which led to a glut of apartments on the market. Then, in October 1987, the stock market collapsed, rocking consumer confidence and wounding the city's economic base. Finally, the crisis in the savings and loan industry led to a tightening of lending requirements that greatly restricted the availability of loans.

In many ways, conditions today are very different and New York appears to be in a much stronger position, in both economic and social terms. Crime rates are far lower, neighborhoods are healthier and the city has seen a steady population growth that promises to keep demand for housing strong.

The city's population has grown by 1.1 million since 1980, to 8.1 million, with 100,000 residents added between 2000 and 2003, despite the effects of the Sept. 11, 2001, terror attack, according to Eric Kober, the director of housing, economic and infrastructure planning for the City Planning Department. ''Real growth in population and income means the housing boom that has taken place in the 00's has had a much sounder fundamental basis,'' Mr. Kober said.

Most economists predict, or at least hope for, a soft landing from a period of galloping price increases, with housing values eventually leveling out.

That hasn't stopped some economists from pointing to weaknesses in the housing boom across the country, including prices that may be greatly inflated in relation to income.

And in a boom fueled by low interest rates, many of them are echoing Mr. Trump's concern about what will happen when rates inevitably rise.

There is, however, another factor at the root of today's market that some economists and mortgage professionals say could spell trouble ahead: an easing of credit standards and the proliferation of riskier forms of adjustable-rate mortgages.

Even with interest rates low, many home buyers are choosing adjustable-rate mortgages over more traditional, and safer, 30-year fixed-rate mortgages. That is especially true in areas like New York and California that have experienced very rapid growth in real estate prices.

According to a survey by the Mortgage Bankers Association, 34.8 percent of new mortgage applications received by lenders nationwide in the week of Oct. 10 were for adjustable-rate mortgages, known as ARM's, whose rates can change after a set period and may rise (or fall) considerably over time.

Precise numbers for the New York area are difficult to come by, but interviews with mortgage brokers and bankers indicate that adjustable-rate mortgages are even more popular here than in many other regions.

Melissa Cohn, chief executive of the Manhattan Mortgage Company, one of the metropolitan area's leading mortgage brokers, said that 56 percent of the loans handled by her office in September were ARM's. A year earlier, ARM's were running at 59 percent of all mortgages. Even in July 2003, during a summer when long-term fixed rate mortgages were at their lowest level in decades, her firm had 47 percent of home buyers and those refinancing old mortgages turning to adjustable-rate mortgages.

In many cases, the call to ARM's seems to be a direct response to escalating home values. Prices have climbed so high in New York that many buyers feel they have no choice but to take out an ARM, whose lower monthly payments may be the only way they can afford the home they want.

''They're buying at their upper limits financially and so they're stretching to get into their new property,'' Ms. Cohn said.

The growth of ARM's is paralleled by an increase in total household debt nationwide; a significant portion is credit card debt that is also subject to a potential rise in interest rates. Concerns have risen to the point that Alan Greenspan, the chairman of the Federal Reserve Board, addressed the issue in a speech on Tuesday, when he played down fears of a housing bubble and declared that family finances remain in ''reasonably good shape.''

THE main reason home buyers choose ARM's is that they carry lower interest rates than fixed-rate mortgages, at least during an initial period before the rate is allowed to fluctuate (after that, increases are typically held to no more than two percentage points a year). In a popular type of loan called a hybrid ARM, the initial period before the rate begins to change can often last three, five or seven years. The shorter the period, the lower the rate.

Many New Yorkers choose a hybrid ARM because they plan to sell their apartment before the initial period expires. This is particularly true of young couples who may buy a small apartment with plans to upgrade within a few years.

But not all ARM's are created equal, and some professionals in the housing industry have voiced concern over the growing popularity of a form of ARM known as an interest-only mortgage. These loans can involve even lower monthly payments than a typical hybrid ARM, because the borrower is not required to make payments against the loan's principal during the period before the rate changes. But they can also involve a greater ''payment shock'' if interest rates go up at the same time that a homeowner must start paying off the principal.

Ms. Cohn believes the mortgage system is sound and does not see a crash in real estate prices on the horizon. But she is not without concerns, especially looking ahead three to five years, when many interest-only mortgages in the New York area switch over and could be hit with an increase in interest rates. ''The greater risk to our economy is the end of these interest-only periods,'' Ms. Cohn said. ''They became very popular two years ago. There's a tremendous concentration in these interest-only ARM's that will all mature together. People were attracted to the appeal of the much lower payment without thinking 'what's going to happen to me in five years.' ''

Interest-only loans were generally designed for well-off borrowers who rely heavily on commissions or bonus income. That would allow them to make principal payments on an occasional basis, such as after they receive a year-end bonus. The loans can also be used to take advantage of a rising market, in which a homeowner believes he can sell again at a profit before his rates change. ''What people understand is that their home goes up in value each year by much more than they can pay the loan down,'' said Douglas Baum, president of New Amsterdam Mortgage, which is based in White Plains. He is also president of the New York Association of Mortgage Brokers. By skipping principal payments, he said, ''they create additional cash flow and use the increase in the market to add the equity to the home.'' Of course, that kind of plan doesn't work if home prices fall.

A hypothetical borrower who took out a $400,000 interest-only loan at 4.75 percent, a common rate in today's market, would start with payments of $1,583 a month, according to Ms. Cohn. If the loan's introductory period was five years, even without a rise in interest rates, the payment would jump at the end of that time to $2,280 a month, once principal payments kick in.

With an annual cap on rate increases of two percentage points, in a worst-case scenario, the monthly payment after five years would rise to $2,763, and could rise or fall again each year.

The short-term advantages are easy to see, although the risks may not always be so obvious. A home buyer who could afford $3,000 a month in mortgage payments could borrow $500,000 with a 30-year fixed-rate loan at 6 percent, according to Nagy Y. Henein, president of the Greater Mortgage Corporation. For the same monthly payments, at least before rates change, the same home buyer could borrow $540,000 with a five-year hybrid ARM at 4.5 percent, or $800,000 with an interest-only ARM, also at 4.5 percent, Mr. Henein said.

One of the risks with an interest-only loan, he pointed out, is that unless the borrower has the financial discipline to make voluntary payments toward principal, he could find himself after 5 or 10 years still owing the entire sum he borrowed. ''Let borrower beware -- beware of what you are embarking on,'' Mr. Henein said.

Jeff Schiamberg, an investment banker, was careful to consider potential risks when he chose an interest-only mortgage for the purchase of a $1.15 million apartment in a building at 49 East 21st Street that is being converted to condos. Using a broker at Manhattan Mortgage, he borrowed $975,000, with a 4.5 percent interest rate that will remain unchanged for five years.

His monthly mortgage payment will be about $3,600 a month during the initial period. When real estate taxes and common charges are factored in, his monthly housing expense will be about $5,000. But, he said, after taking a deduction for interest payments from his income tax, his monthly housing cost will be about the same as the $3,000 a month he now pays in rent in the West Village.

Mr. Schiamberg said he and his wife, Jennifer, were able to contemplate the purchase of an apartment over $1 million because of the lower monthly payments allowed in an interest-only ARM. ''We were able to buy a larger place and on an after-tax basis pay about what we're paying now for rent,'' said Mr. Schiamberg, 33, who expects to sell the condo before his interest rates are set to change in five years.

''What we're thinking is regardless of what the economy is five years from now, we'll likely make money by selling the place,'' he said. If not he expects to have the resources to pay off the mortgage in a lump sum and stay in the apartment because ''some day prices will come back.''

One of the reasons interest-only mortgages and other ARM's have increased in popularity is that banks like them, according to Steven B. Schnall, chief executive of the New York Mortgage Company. He is also chief executive of the New York Mortgage Trust, a real estate investment trust that buys mortgage-backed securities.

Since the money a bank or other large institution borrows is often subject to short-term fluctuations in interest rates, the ability of ARM rates to change over time can provide a hedge against future rate increases.

The loans appeal to banks regardless of whether they hold onto the mortgages or sell them on the secondary market to investment trusts, like Mr. Schnall's, or Fannie Mae, the government-chartered company that helps finance the mortgage industry.

''We're underwriting ARM's very cautiously because we're looking to be a long term owner of these loans,'' said Mr. Schnall, who said about half the loans his company makes are ARM's.

But others may not be as careful. Mr. Schnall said he frequently evaluates the credit data backing up groups of securitized ARM's, including factors like loan-to-value ratios, which compare outstanding principal to the appraised value of a home.

''When we look at some of these, you say, 'I wouldn't want to be the one holding that portfolio,' '' he said. ''The loan-to-value ratios are high, the credit scores are not that great and they are adjustable-rate mortgages. Is there going to be a credit catastrophe? I think most people bet not. But I'd say there needs to be caution.''

Mortgage professionals say the current housing boom across the country has been accompanied by a general loosening of the standards by which banks decide who is eligible for a mortgage.

In the early 1990's, banks typically would allow borrowers' monthly mortgage payments equal to up to 28 percent of their gross monthly income. Total debt service, including mortgage payments, could rise to 36 percent. Today, some lenders allow up to 42 percent of gross monthly income to be spent on mortgage payments, with total debt payments rising to 50 percent or more in some cases.

Lending decisions are largely driven by credit scores, and, with lenders relying on computer programs developed by Fannie Mae to evaluate loan applications, borrowers with good credit are allowed larger payments than in the past.

''If I had to look at one sector, I'd be watching underwriting standards,'' said Keith T. Gumbinger, a vice president for HSH Associates, a publisher of financial data that tracks the mortgage industry. Lenders were working overtime the last two or three years to keep up with a surge in refinancing sparked by low interest rates. Now that rates have jogged upward, the refinance business has been more than cut in half, leaving lenders hungry for new business. Lenders made $3.8 trillion in mortgage loans last year, compared with a projected $2.6 trillion this year, according to the Mortgage Bankers Association. ''It's always a curiosity as to whether underwriting standards are being diminished in order to keep up volume,'' Mr. Gumbinger said.

A market with soaring prices has put remarkable pressure on buyers at the same time that it has fostered the illusion that values can go in only one direction. Still, some are aware of the potential pitfalls.

Mark DiMassimo, chief executive of DiMassimo Carr Brand Advocates, an advertising agency, used an interest-only mortgage, obtained through Manhattan Mortgage, to cover about half the price of a $1.4 million home in Rye, N.Y., last month. The rest of the purchase price came from the proceeds of the sale of his Manhattan co-op. At an interest rate of 5.25 percent, which will remain set for seven years, he feels he has taken a conservative stance, combining a large amount of equity with the lower rate and flexible payment structure provided by an ARM. His monthly payment is $3,171, but he plans to make payments against the principal on an ongoing basis.

Mr. DiMassimo said he learned from the experience of his parents, who struggled in the down market of the late 1980's and early 1990's, when they were unable to sell their house in St. James, in Suffolk County, on Long Island. It took his parents several years to find a buyer, he said, and they finally sold the home for about 20 percent less than they paid for it 12 years earlier.

Mr. DiMassimo, 42, said part of his motivation in moving this summer was that he wanted to sell his Manhattan apartment before prices fell. ''I do really believe,'' he said, ''we were buying during a bubble.''