Debt Bubble Stretches to Breaking Point

A growing number of home buyers are avoiding higher rates, for now, by financing their purchases with adjustable-rate mortgages. Many of these offer rates as low as 5.5% for the first five years and then adjust annually thereafter. Buyers can even get a lower rate -- as low as 4.2% -- if they take out a mortgage that adjusts annually after the first year.

At Washington Mutual (WM Quote), adjustable-rate mortgages accounted for 53% of all new mortgages in the first quarter of 2004, up from 27% in the first quarter of 2003. Nationally, adjustable-rate mortgages now account for 35% of all mortgage applications, according to the Mortgage Bankers Association of America.

Fed Chairman Alan Greenspan told the Credit Union National Association in a February speech that rising mortgage debt, up to $6.8 trillion at the end of 2003, wasn't a problem because lower interest rates had reduced the amount that consumers had to pay each month to service those mortgages. Greenspan didn't say what would happen to both borrowers and lenders when higher interest rates raised the monthly payments on those mortgages. I think we'll find out when the shortest of those adjustable-rate mortgages start to adjust in about a year.

2. A bubble expands faster as the cycle nears its end. Anyone watching the mortgage market knows that the excesses of a bubble don't moderate as the bubble matures. Instead, they just get more excessive. Countrywide Financial (CFC Quote) funded $15.7 billion in adjustable-rate mortgages in April 2004, up 130% from a year ago.

This tendency for bubbles to become more excessive as they mature is built into modern financial systems.

Take the interplay between credit cards issued to consumers and the asset-backed securities built and sold by Wall Street. Asset-backed securities are debt instruments backed by a bundle of loans -- in this case, a bundle of credit card loans. The investor that buys the asset-backed security, usually an institution, receives most of the cash flow from the interest paid on the underlying loans.