- The Washington Times - Tuesday, February 7, 2006

First of three parts.

If your home is a castle of debt with ramparts of low-cost loans to keep the empire secure and separated from economic reality, you are not alone.

In this, the golden age of financing, Americans have been encouraged to borrow and to trade up and up to more-expensive houses and lifestyles — but the bill is coming due.

More people own new homes, drive new cars, possess the latest high-tech gadgets. The debt-financed splurge has caused an explosion in the U.S. trade deficit and debt to the outside world.

The current account deficit of more than $700 billion in the past year, which is larger by far than any ever experienced by a nation without causing a major financial crisis, leaves the U.S. vulnerable to the changing moods of foreign investors and to a potentially dramatic reversal that could send interest rates soaring and precipitate a recession.

The debt explosion, driven by a doubling of home-mortgage debt to $8 trillion since 1998, also poses substantial risks to individual borrowers and to those who lend them money.

Many Americans have no savings, but do have debt burdens that consume most of their paychecks each month. They would be quickly overwhelmed as a result of a job loss or other personal or social calamity.

The danger of having no financial cushion other than the equity value in a house was seen last summer when Hurricane Katrina devastated the homes, finances and well-being of millions of Gulf Coast residents, many of them left with no jobs and no place to live.

“The consequences can be dire,” said Mark Skousen, economics professor at Columbia University. “Most people undersave and overspend at a dangerous rate” in the United States.

“We’re in a weak position to deal with disasters,” he said.

The federal government has gone hundreds of billions of dollars deeper into debt to help stricken regions recover from hurricanes and other natural disasters each year, because people have so few resources of their own to fall back on.

Debt to the world

As the country digs itself deeper into debt, it creates another hazard, Mr. Skousen noted.

“The world owns our debt” from accumulated external deficits totaling $8 trillion. The biggest debt holders are Asian nations, such as Japan and China.

“If foreign investors decide to place their funds elsewhere, we could face a sharply declining dollar, a stock market crash, or worse,” Mr. Skousen said.

Other countries that spent and borrowed profligately — notably Argentina and Russia in the late 1990s — fell into financial crisis and deep recessions from which it took years to recover.

“Right now, the rest of the world owns $3 trillion more of us than we own of them,” said celebrity investor Warren Buffett in an address to business students last month. “In my view, it will create political turmoil at some point … I think there will be a big adjustment.”

Former Federal Reserve Chairman Alan Greenspan frequently warned of the dangers of America’s fast-mounting deficits and debt to the world — and the possibility of a reversal of fortunes.

Mr. Greenspan and other federal regulators voiced concern about the proliferation of easy and risky financing that has enabled homeowners to go so deeply into debt. In December, they issued rules to curb the most abusive mortgage-lending practices.

Mr. Greenspan earlier co-authored a study that concluded that the cashing-out of home equity to finance a consumer-spending spree this decade is the principal reason why U.S. household savings have fallen below zero.

Newfound money

The combination of easy credit offered by an army of mortgage financiers and an unprecedented willingness by Americans to go deeply into debt to maintain affluent lifestyles has put the economy on risky ground, said Dimitri B. Papadimitriou, president of the Levy Economics Institute of Bard College.

“From 2000 onward, borrowing as a percent of income has exploded” to record levels well beyond previous highs set in the late 1980s, he said.

While in past decades, Americans binged on credit card debt, in the 2000s, the preferred way of going into debt is first and second mortgages.

Consumers learned that the easy credit terms now available on mortgages enable them to borrow much larger amounts than they can with credit cards, and the debt does not have to be paid off for five to 40 years, if ever.

Another advantage is that, unlike credit-card debt, the interest on first and second mortgages usually can be deducted from taxes.

The discovery of easy mortgage financing led U.S. households to escalate borrowing to more than $1 trillion for the first time in history in 2004 and 2005. Before 2000, consumers had never borrowed more than $488 billion in one year, according to Federal Reserve statistics.

The growing mountain of debt means debt-service burdens have climbed to record heights, even though the interest rates on the mortgages are the lowest in a generation, Mr. Papadimitriou noted.

Risky wealth

A survey by A.C. Nielsen last year found that, despite having some of the highest incomes in the world, Americans are more cash-strapped than the citizens of any other nation, partly because they are saddled with huge debt payments.

Nearly a third of Americans say they have no cash left after they have covered essential living expenses each month. That compares with 7 percent of consumers in the poorer nations of India, China and Mexico.

Because growth in the economy depends on continued growth in consumer spending, which fuels 70 percent of economic activity, the excessive borrowing puts both consumers and the economy at risk, Mr. Papadimitriou said.

“Given the highly leveraged position of households, even a modest drop in housing prices would reduce their wealth considerably” and force them to borrow and spend less, he said.

Any significant pullback in consumer spending could plunge the economy into a deep recession — with the loss of 5 percent of economic output — if it is not offset by higher federal spending and deficits, he said.

But the government, itself saddled with record-high deficits and facing enormous liabilities to finance the retirement of the baby boomers, is in no condition to come to the rescue.

Cash cow

The debt revolution arose quietly out of the housing boom.

As house prices spiraled beyond the ability of many borrowers to pay, mortgage-finance companies stretched the rules to help buyers get their piece of the American dream while maintaining an affluent lifestyle.

Meanwhile, homeowners saw the soaring value of their homes increasingly as a source of cash rather than a nest egg for retirement.

Keith Leggett, senior economist with the American Bankers Association, said banks liberalized their lending terms to comply with consumers’ desire to free up their home equity — in past eras, a largely illiquid asset — and convert it into cash.

Withdrawals from home equity exploded to an estimated $800 billion last year from $66 billion in 2001. Although some of that was used to remodel homes and pay down credit-card debt, homeowners used most of it on items from cars to college education, surveys show.

Consumers tap into their accumulated home value using home-equity loans to cash out refinancings. Initially, this was accomplished with traditional 30-year loans and adjustable-rate mortgages (ARMs). But as housing prices climbed and consumers became increasingly extended, lenders had to come up with more inventive means of proffering debt.

What came into vogue in the past two years were mortgages that start out with low monthly payments, such as “interest-only” loans that require payment of interest only in the first five years or so, and “option ARMs” that enable consumers to decide whether to make a minimum payment or add in principal each month.

These exotic mortgages, for which payments can explode in later years when the loans are fully indexed and adjusted to market rates, started out as a trickle but quickly turned into a flood that reached nearly $600 billion last year.

Inventive mortgages

In California and other high-priced housing markets such as Washington, 55 percent to 80 percent of home buyers snap up the unconventional mortgages — often because that is the only way they can afford to purchase a house.

Mortgage bankers have become even more inventive as short-term interest rates crept up in response to the Fed’s rate-raising campaign in the past year and a half, raising the cost of adjustable-rate mortgages.

Low introductory rates of 1 percent to 2 percent were introduced, and they started routinely approving loans that require 50 percent to 60 percent of a borrower’s gross income, before taxes, to pay each month. Loans financing 100 percent to 120 percent of a house’s price already were routine.

Old borrowing rules such as the need for a good credit history or stable income were eliminated. Many lenders now provide loans to borrowers who have no proof of income or who have just emerged from bankruptcy and have tax liens on their homes.

These offerings enticed borrowers, even though the extraordinarily low payment rates advertised may last only a few months and the mortgages often include other harsh terms, such as penalties for prepayment of the loans.

By mid-2005, half of new home buyers were financing 100 percent of their home purchases and one in five were spending half their disposable income on housing.

Christian Werner, chief executive of New World Mortgage, said some people hoping to buy into the American dream by going deeply into debt may end up with the American nightmare instead.

“Innovation in mortgage products is great, but it is absurd for people in our industry to place credit-challenged consumers into” risky mortgages with six-month deferred payments or those allowing consumers to tap 128 percent of a home’s value using a credit card, Mr. Werner said.

Consumers need better education about the costs of debt, rather than new loans allowing even previously bankrupt people to get up to their ears in debt again, he said.

“I’m sorry, but if you are just out of bankruptcy, you need to go into credit time-out for a while,” Mr. Werner said.

Part II: Too-good-to-be-true offers leave borrowers in a bind

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