• Are Mortgage Borrowers Rational?

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    "I believe in people. I believe most people
    are rational."

    ~ Brian Wesbury, as appeared
    on CNBC June 20th

    Earlier this week economists Gary Shilling and
    Brian Wesbury squared off on CNBC to discuss the current state of
    the housing market. Wesbury, the younger and far more frequent guest
    over the past eight years, was bullish: the market is simply "correcting
    back to normal." Shilling, the bear, subscribes to the housing
    bubble theory. As evidence, last year 40% of home sales were speculative
    in nature — that is, to second home buyers and investors. According
    to Shilling, it would take a 35% drop in housing prices to restore
    the long-term balance between median home prices and the Consumer
    Price Index. What caught our attention was the essence of Wesbury's
    assuredness: there never was a bubble because most people are
    rational.

    In a sense, Brian Wesbury is right. Man tends to
    act rationally to pursue his own interests and remove discomfort.
    Markets would fail if man always acted randomly and without purpose.
    Imagine a household attempting to minimize its income and maximize
    prices paid at the grocery store. Its members would quickly perish.
    From 2001 to 2004 the Federal Reserve put the price of mortgage
    credit on sale as it drove short-term interest rates through the
    floor. Can existing and would-be homeowners be faulted for lining
    up in droves?

    A long-time friend from Scottsdale, Arizona (inventories
    up ten-fold the past year) points out a distinction in the behavior
    of the debtor class. Some have clearly acted responsibly: they consolidated
    their debts into tax deductible mortgages, locked in the lowest
    long-term rates in 40 years, and tossed the interest savings into
    their rainy day and investment jars. From a consumption standpoint,
    little has changed except that these old school borrowers pocketed
    a windfall compliments of their friendly neighborhood central banker.

    Others — to put it mildly — have gotten carried
    away. Mortgage equity withdrawal (a.k.a. going deeper into debt)
    was roughly $2.2 trillion over the past three years. Homebuying
    on margin (peddled as "the American dream") greatly expanded
    in the credit-challenged "subprime" strata. Debt service
    costs (household financial obligations at nearly 19% of disposable
    personal income) have never been higher, even with generously low
    interest rates.

    Thanks to the young and reckless, today housing's
    vital signs look less than encouraging:

    • 29% of mortgages assumed in 2005 are now underwater.
    • 16% of those with mortgages pay over half of their income on
      housing, up from 2% five years ago.
    • 22% of the $9.3 trillion residential mortgage market is now
      subprime.
    • $2.7 trillion of adjustable-rate mortgages are expected to reset
      in the next 18 months with payments increasing on average 45%.
    • Total home inventories and the inventory/sales ratio are at
      record highs.

    On Main Street, Madison Avenue, and especially
    Wall Street, anything worth doing is worth overdoing. A good idea
    inevitably wilts under the sunlight of too much attention. So, too,
    the mortgage refi bloom is succumbing to over-exposure.

    Man tends to act rationally until you place him
    in a group and offer him something for nothing. Over a century and
    a half ago Charles Mackay, in his classic Extraordinary Popular
    Delusions and the Madness of Crowds, observed that "men
    go mad in herds." 130 years later historian Barbara Tuchman,
    in The March of Folly, chronicled the recurrent "pursuit
    of policy contrary to self interest" from the Battle of Troy
    to the Vietnam War. More recently Bill Bonner co-authored two highly
    readable and entertaining books crash testing his theory on human
    progress: in science and technology man tends to learn; in love,
    finance, and war he makes the same mistakes over and over. This
    play of perpetual blunder has many acts: fear, skepticism, rationalization,
    exuberance, denial, resentment, and finally resignation. Only the
    actors change.

    For some, folly is a participatory sport, while
    others choose to watch from the sidelines. Gary Shilling has been
    around long enough to see this game before. He recognized the manias
    of Japan in the late '80s and tech-land in the late '90s. He
    now claims the mortgage market went manic
    after the Greenspan
    Fed opened the credit spigot to fend off a deflating tech balloon
    in 2001. We have no knowledge of Brian Wesbury's view on "Japan,
    Inc." in 1989, though six
    years ago he jumped on the New Economy bandwagon
    . Today he dismisses
    the housing naysayers and assures us that the market is "pulling
    back to normal."

    We
    have little doubt who's crystal ball is more popular with CNBC viewers.

    June
    24, 2006

    Kevin
    Duffy [send him mail]
    is a principal of Bearing Asset Management.

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