Should we stop worrying that the debt bubble created by the

Federal Reserve

since the 2000 market crash could still burst?

No way. Just the opposite, in fact. My three rules of bubbles, identified and explained here, say we're approaching the most dangerous period in the life of any bubble: the time when it is most in danger of breaking.

I know it's tempting to stop worrying about the debt bubble that was created as the Fed tried to moderate the effects of the market crash and the terror attacks of Sept. 11, 2001. The parts of the U.S. economy most sensitive to interest rates are showing few signs of crumbling in the face of the huge increase in 10-year Treasury yields since March 12 (the yield Friday was at 4.66%), and amid increasingly clear statements from the Fed that it will raise its target interest rates this year.

Sales of existing homes are running near a record pace. Consumer spending keeps chugging along, at an annualized rate of 5% in April, and retail sales climbed by an annualized 4.5% in the first three weeks of May. Even car sales are holding up; in the first four months of 2004, auto sales were up 3.1% from a year ago.

But the Three Rules of Bubbles tell me that it's too soon to stop worrying. We've hardly begun to correct the distortions that cheap money has created. Instead of deflating gradually as interest rates have started rising, the bubble has continued to swell in many sectors. The level of financial risk in the economy is still climbing.

So what are these three rules?

1. A bubble expands far longer than anyone expects.

Let's look at home sales. Logically, higher mortgage rates -- rates on a 30-year fixed-rate loan are now about 6.3%, up from the low of 5.1% in June 2003 -- should slow the pace of sales and start to bring down home prices. So, again logically, the home-mortgage bubble should be starting to deflate.

But exactly the opposite is happening. Sales of existing homes grew by 2.5% in April to a seasonally adjusted annual rate of 6.64 million homes. The price for a house nationally climbed to an average $176,000 in April, up 7.3% from a year ago. Instead of cooling the housing market, higher rates actually have created a flood of new buyers who fear getting shut out of the market if rates rise too high.

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.


Washington Mutual

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, 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


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.

Right now, securities backed by credit cards are very hot products because the underlying rates on the cards float -- nirvana for investors bailing out of fixed-rate bonds by the prospect of higher rates.

Wall Street has sold $185 billion in asset-backed securities so far this year, about 22% more than at this time in 2003, Merrill Lynch calculates. That has created demand for the underlying credit card loans needed to create these securities. That, in turn, has made it easy for credit card issuers to sell their credit card loans to Wall Street for repackaging. In other words, credit card companies can sell just about as much credit card debt as they can create.

So while direct-mail marketing of cards is down, largely because it has been less effective lately, the level of total marketing is up. No debt-pressed consumer need worry that he can't get more credit from somebody in this market. Again, this stretches out the day of reckoning, because a consumer with large card balances can switch those balances to another card, probably at a lower rate, at least for a while. But it does make the eventual reckoning more painful.

3. It's tough to admit the cycle is over.

The impulse is to keep inflating the bubble. That's why they finally pop. Consumers stretched by mortgages, home equity loans and credit card debt don't want to admit that the low-interest-rate cycle is over. They'd rather borrow more, especially because it's easier than ever right now, than cut current spending to pay off that debt. But consumers aren't alone. Some consumer product companies are probably even more hooked on issuing credit than consumers are on using it.

General Motors

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used to be a car company. In 2003, the company's finance division, General Motors Acceptance Corp. (or GMAC), reported profits of $2.8 billion. General Motors' car business showed profits of just $1.1 billion. The finance division accounted for 71% of the "car" company's profits. Profits at GMAC grew by 65% from 2001 to 2003.

GMAC's growth gives General Motors a huge problem. With car sales flat or falling and auto profits down so far this year, the company needs growth from its financing division to meet its growth targets, but profit margins in GM's main business of lending to finance car loans, as well as auto loan volume, are down.

Of course, the company could bite the bullet and simply admit that it wasn't going to meet Wall Street's targets. But anyone who remembers how tough it was for technology company executives to admit growth had slowed in 2000 won't think that's at the top of GM's list of solutions. No, the company plans to get more growth out of GMAC by expanding the company's mortgage and insurance businesses. I'm sure that a company that offers 0% auto loans will think of something that will work. For a while.

These three rules for bubbles don't pinpoint when the bubble will burst. And my examples hardly create a complete list of all the problems that lie in wait for the economy and the markets as we work through Mr. Greenspan's latest financial bubble.

The rules do suggest what to look for: Institutions that have the money to lend are so pressed by their own need to grow that they will make loans without much regard for the ability of borrowers to repay them.

Let's look at one more issue. The business of lending to hedge funds is incredibly lucrative for banks on and off Wall Street at a time when banks are facing profit pressure. One-quarter of hedge funds surveyed recently by Greenwich Associates said their banks had extended credit lines in the last six months. One-third of these funds reported that they had increased their use of leverage (using borrowed money to buy stocks and bonds) in the past year. I don't believe for a moment that all of those hedge fund loans went only to the most creditworthy funds. And I know for sure that leverage, which produces outsized profits in good markets, increases the risk that, in a bad market, a moderate loss will turn into a huge one.

I'd like to be more specific about the risks in the financial markets as this cheap money bubble plays out. One of the most frustrating things about this market and about the interlocking relationships so characteristic of our financial system is that it is so hard to figure out who will get left holding the bag.

I am certain, however, that this isn't the time for investors to let their guard down. This bubble is unlikely to break with the kind of pop that took down the entire stock market in 2000. But it is even less likely to deflate gently and painlessly.

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jubak at