Federal Reserve Chairman Alan Greenspan yesterday expressed concern that the growing use of riskier new mortgages is helping push up home prices to "unsustainable levels" in some local markets.
Home prices in some areas of the country may fall when the market cools, but that probably would not cause serious harm to the overall U.S. economy, he told Congress's Joint Economic Committee.
The economy continues to expand at a decent if uneven pace, Greenspan said, indicating that the Fed probably will continue to raise short-term interest rates gradually to keep inflation under control
"The U.S. economy seems to be on a reasonably firm footing, and underlying inflation remains contained," he said, adding that the Fed can therefore raise rates "at a pace that is likely to be measured." Stock prices were little changed, as Greenspan did not signal heightened worries about rising prices or slowing economic growth.
But Greenspan did note some troubling aspects of the booming housing market. He highlighted the recent surge in interest-only loans, which allow borrowers to lower their monthly bills by paying only interest for the first years, and other forms of adjustable-rate mortgages.
"The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern," he said.
Nearly a fourth of the mortgage loans made this year nationally have been interest-only, according to LoanPerformance, which tracks loan originations. In the Washington area, more than a third of home buyers are using interest-only mortgages, up from about 2 percent just five years ago.
Other varieties of adjustable-rate mortgages have proliferated. There are up to 200 kinds of mortgage products on the market, all with different interest rate schedules, down payment requirements, payback terms, fees and potential penalties, said Douglas G. Duncan, chief economist of the Mortgage Bankers Association.
The "exotic" loans Greenspan mentioned probably were a reference to the "option ARM," which permits borrowers to decide themselves how much to pay, how long the loan term should be and when they can convert from a fixed rate to a variable rate, or back to a fixed rate, Duncan said.
Greenspan's comments will signal to lenders that they should examine the potential risks of foreclosure if these new kinds of loans turn sour, Duncan said. "It's an alert to the leadership of lenders to pay attention to this, and they will."
Greenspan's remarks also are a warning to consumers to be wary of buying homes in high-priced markets if the only way they can do so is with a low down payment and an interest-only loan, said Anirban Basu, chief executive of Sage Policy Group, an economics consulting firm in Baltimore. Basu predicted that in 5 to 10 years, there will be a "huge surge of foreclosures" when interest rates rise, home values level off and homeowners become unable to pay their bills.
"What the chairman is saying to people is 'be careful,' " Basu said. "This warning should be heard louder in some markets than in others."
Greenspan repeated that he does not see a national housing bubble, a situation in which price increases are fueled by speculation based on expectations that they will keep rising. But he suggested that smaller bubbles are apparent, noting "signs of froth in some local markets where home prices seem to have risen to unsustainable levels."
One major factor in the run-up in prices has been low mortgage rates, he said. But he also said real estate speculation and loose mortgage lending may be pushing up some prices.
"The apparent froth in housing markets may have spilled over into mortgage markets," he said, referring to lending practices.
The Fed and other bank regulators recently urged lenders to tighten standards for home-equity loans, for example by requiring more documentation from borrowers and more closely monitoring their changing financial health over the life of the loan. The agencies have begun discussing whether to recommend similar changes in mortgage lending. The regulators do not write the standards, but issued the suggestion as "guidance," warning that some borrowers may have trouble paying back their loans.
With interest-only loans, borrowers may make big profits if home price appreciation continues. But if prices fall, they risk owing lenders more than their houses are worth. If a borrower cannot afford the monthly payments -- because of rising interest rates or a job loss, for example -- he or she may not be able to sell the home for enough to pay off the loan. And prices do sometimes slide, Greenspan said.
"We certainly cannot rule out home price declines, especially in some local markets," he said.
Greenspan mentioned several reasons that regional drops in housing prices are unlikely to significantly affect the national economy.
Although a fall or even flattening of house prices would slow the growth of consumer spending, that should be offset somewhat by rising business spending as economic expansion continues, he said.
Also, mortgage lending in the past was more concentrated in regional financial institutions, making them more vulnerable to a downturn in the local real estate market. Today, with nationwide banking and the development of an extensive secondary market for mortgages, lenders disperse the risk very widely.
Gus Faucher, senior economist at Economy.com, said he thinks Greenspan may be too sanguine about the potential national economic impact of regional housing market slowdowns, noting that the cities that could be most affected -- San Francisco, Los Angeles, New York City, Boston and Washington -- are among the nation's most important financial centers.
"I wouldn't be quite so optimistic," Faucher said. "There could be macroeconomic impacts even if the bubbles are just localized. . . . If there is a serious correction, it could affect those economies and spread to the broader economy."
Greenspan repeated that he expects the housing boom to cool eventually as home loan rates rise. But mortgage rates have fallen over the past year even as the Fed has raised short-term interest rates.
The Fed has lifted its benchmark short-term interest rate to 3 percent from 1 percent over the last year. Greenspan strengthened expectations that Fed officials will raise the rate to 3.25 percent at their meeting at the end of this month, and to at least 3.5 percent by the end of the year.
Meanwhile, the average rate on a 30-year fixed-rate mortgage fell this week to 5.56 percent, down from 6.30 percent a year ago.