Greenspan Issues Warning on Use of Risky Mortgages

Federal Reserve Chairman Alan Greenspan on Monday warned home buyers to be wary of exotic mortgages that allow them to hold down monthly payments or defer principal payments in the early years.

If the red-hot housing market cooled off, Greenspan said, “these borrowers, and the institutions that service them, could be exposed to significant losses.”

Greenspan’s warning came as sales of previously occupied homes rebounded to a near-record height and their prices reached a new peak, according to a report released Monday.

Although the central bank chief criticized the growing use of “interest only” mortgages and other risky loans that allow buyers to afford expensive homes through lower initial payments, he took comfort from a Fed estimate that most homeowners held mortgages equaling less than 90% of their home’s value.

“The vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices,” Greenspan said in a speech beamed by satellite from Washington to an American Bankers Assn. convention in Palm Desert.

Mark Zandi, president of Economy.com, said Greenspan had two messages.

“He said housing has turned increasingly speculative, and a correction in the market is coming,” Zandi said. “But he also said that the correction won’t affect the great bulk of homeowners.”

Greenspan’s remarks indicated to analysts that the Fed was not through with its campaign of raising interest rates. He suggested frustration that the Fed had raised its benchmark short-term interest rate from 1% to 3.75% over the last 15 months, and yet the average rate on 30-year mortgages had dropped half a point to 5.75%.

“Implicitly,” Zandi said, Greenspan is saying, “ ‘I can keep raising rates, and most homeowners won’t suffer.’ ”

Low interest rates on mortgages, in turn, have lifted home values, prompting a binge of refinancing and home equity loans. Greenspan estimated that homeowners had used about half the proceeds either for personal consumption or for repayment of credit card debt.

One result has been a nose dive in the personal savings rate, to minus 0.6% of disposable income in July.

“So many Americans are consuming by using their home equity,” said Alan Skrainka, chief market strategist at investment firm Edward Jones. “If you can’t afford a standard mortgage, you probably shouldn’t be buying a home.”

Greenspan delivered his speech hours after the National Assn. of Realtors reported that sales of existing homes had shot up to an annual rate of 7.29 million in August, 7.8% higher than a year earlier and higher than any month except June’s 7.35 million.

“Apparently,” Greenspan said, “a substantial part of the acceleration in turnover reflects the purchase of second homes -- mainly for investment or vacation purposes.” He said second homes accounted for 14% of all sales at the end of last year, double the level in 2000.

The median sales price in August was $220,000, or 15.8% higher than in the same month last year. That was the greatest 12-month increase since 1979. The rise was steepest in the West, where it was 20.1%.

Greenspan scolded the providers of “novel mortgage products,” including some requiring no down payment and others allowing 40-year repayment schedules. A drop in home prices or an increase in mortgage rates could increase the risks of defaults on these and other risky loans. But he also said rising home prices had lifted some risky mortgages into the “safe” category.

Gary McKitterick, a partner at law firm Allen Matkins Leck Gamble & Mallory, said such reassurances “are aimed at calming the public. We’ve been talking about a real estate bubble for two years now, and the thought of bubbles bursting leaves people a little anxious.”

McKitterick added that Greenspan’s message to the real estate industry was tougher: Don’t get carried away with financial instruments that put the home-buying public at risk.