Federal Reserve Chairman Alan Greenspan cautioned yesterday that certain types of increasingly popular, risky home mortgages could be "disastrous" for some borrowers betting on ever-rising house prices.
"There's potential for individual disaster there," Greenspan told the House Financial Services Committee. It was his strongest warning yet about the potential pitfalls for consumers and lenders in the nation's red-hot housing market.
Greenspan also warned lenders to "fully appreciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change."
Greenspan discussed the housing market while delivering an upbeat assessment of the overall economy in his semiannual report to Congress. Employment, retail spending and business investment have all risen in recent months, he noted.
"The U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends," he said.
Greenspan also made it clear that the Fed plans to continue gradually raising its benchmark short-term interest rate to keep inflation under control. He noted inflation pressures from high energy prices, businesses' increasing ability to raise prices, the improving labor market and the slowdown in growth of workers' productivity, or output per hour.
The Fed has raised its federal funds rate -- the interest rate charged on overnight loans between banks -- nine times in the past year, to 3.25 percent. Greenspan's comments prompted many analysts to predict that Fed officials will keep lifting it steadily higher in coming months, to at least 4 percent by year-end.
Greenspan's comments "dashed any hopes that the Fed would hint at a near-term change in its course" of raising rates, said Gary Bigg, an economist at Bank of America Corp.
Despite the Fed's actions, longer-term interest rates -- which are determined by financial markets -- have fallen in the past year. Mortgage rates, for example, are lower today than a year ago, helping power the housing boom.
The value of all U.S. residential real estate rose 15 percent in the first quarter from the first quarter of 2004 -- faster than the growth in after-tax income, according to the latest Fed data.
Historically, the kind of rapid price appreciation seen recently "does not go on" forever, Greenspan said. Prices could decline in some real estate markets, he said.
Some borrowers assume that continued gains will enable them to pay back various types of mortgages that initially involve very low costs, he said. They include home loans that require no down payments, that initially require payment only of the interest owed and none of the loan principal, or that start with very low interest rates that can rise rapidly and steeply over time.
Those mortgages have surged in popularity over the last year, enabling people to buy houses they could not otherwise afford and helping to further pump up prices, he said. But some borrowers could find it difficult to make their loan payments if interest rates rise sharply or their incomes fall. And if prices flatten or decline, a borrower might be unable to sell a house for enough to pay off such a loan.
Greenspan said such riskier loans account for only a small fraction of all the mortgages outstanding, and therefore do not pose a threat to the overall economy. However, Fed officials see the loans as "the tip of an iceberg we're concerned will get larger," he said.
Such mortgages in "individual cases, could prove disastrous," he said.
Greenspan said it is hard to know whether homes are overvalued on average nationally. But he repeated that he sees "signs of froth in some local markets where home prices seem to have risen to unsustainable levels." And he added that some regional markets appear to be charged "with speculative fervor."
The National Association of Realtors estimates that 23 percent of U.S. homes purchased last year were for investment, and that 13 percent were second homes. Meanwhile, almost one of every four new mortgages are interest-only loans, according to LoanPerformance, a company that tracks loan originations.
Greenspan said long-term interest rates remain low for several reasons, including global capital flows, low inflation and investor expectation that economic stability will continue for many years. He warned financial markets against underestimating the risks involved in some complex investment strategies: "History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress."
Greenspan's testimony yesterday and today, when he is scheduled to deliver the identical report to the Senate Banking Committee, could be his last on behalf of the Fed. He has indicated that he intends to step down as chairman when his term expires Jan. 31, after 18 years on the job. However, he could stay on in the position until a successor is confirmed.
White House officials have indicated that they do not plan to nominate a new Fed chairman until early next year, which would leave little time for Senate confirmation before Greenspan's term ends.
"If no successor is in place, Mr. Greenspan will likely remain as chairman after his term on the Board formally expires," economists at UBS Securities LLC wrote yesterday. "That scenario is quite possible."