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updated 2/5/2004 7:12:23 PM ET 2004-02-06T00:12:23

America's steamy affair with credit has kept the economy growing. Time for a cold shower?

Now that the great refinancing boom is over, it seems odd for a mortgage bank like New Century Financial to be lending more than ever. But this Irvine, Calif. institution doesn't lend to just anyone. Its customers are so buried in bills they have no choice but to tap the value of their homes to pay them off — whether or not rates are rising.

"If your home keeps appreciating, why not use the equity?" says New Century Chief Executive Robert Cole.

Investors agree, pushing up shares of New Century and other so-called subprime lenders like Saxon Capital and Novastar Financial to more than double their levels a year ago. Subprime borrowers — generally ones with a scary debt-to-income ratio or a trail of delinquencies — took out $350 billion or so in mortgages last year, or 10% of total new mortgage loans. The demand is not expected to fade this year.

GDP is strong and interest rates are low, so it's easy to get caught up in the promise of a recovering economy. But there are those nagging doubts, like consumers' addiction to borrowing. Consumer debt hit an alltime high of $2 trillion in November, up 41% in five years. A record 1.6 million households filed for bankruptcy last year. And jobs needed to mop up all the red ink are still scarce, with only 1,000 generated in December.

The subprime boosters argue: Don't worry. In fact, they say, the borrowing binge is a blessing to the economy, helping to extend that most crucial of economic stimulants, the consumer buying spree. Douglas Duncan, chief economist of the Mortgage Bankers Association, says the impact that subprime refinancers have on the economy is often underestimated because they act in unexpected ways. This particular breed of debtors will continue to borrow against the value of their homes even as interest rates rise. That's because the rates on their credit card bills will always be higher, and they have precious little cash to pay them off.

Translation: Desperate debtors will help cushion the blow from most other serial refinancers, who have stopped using their homes as personal ATMs.

'Housing bubble'
If New Century customers are any guide, these subprime borrowers are worthy of their name. New Century's borrowers, most jumping into adjustable-rate mortgages now, have on average accumulated $20,000 in unsecured debt. Their home equity is only 18%. But the average American household has nothing to brag about either. The typical American mortgage holder has $4,400 worth of unsecured debt, and his equity has fallen to 54% from 70% two decades ago.

Even if you're convinced these borrowers are good risks, you still have to wonder about the value of the homes backing their loans. Morgan Stanley economist Stephen Roach bemoans "the extraction of cash from overvalued assets such as homes," to quote his recent report, titled "False Recovery." Roach has been bellyaching about a housing bubble for years now, and he's still fighting the tide.

The same week of his latest screed, J.P. Morgan Chase announced it was paying $58 billion for credit card giant Bank One to increase its exposure to the mighty American consumer. Why listen to a mere scribbler when the big money is saying the opposite?

"All I hear is 'bubble this,' 'bubble that,'" fumes Otis Bradley, a Gilford Securities analyst who thinks New Century stock should be trading a fifth higher. "But the value of homes keeps going up."

One nightmare scenario is what industry insiders call "payments shock," which doesn't require any great drop in home prices. Thanks to all those popular adjustable-rate loans, whose rates typically float after one or two years, homeowners face the possibility their interest payments may rise even if their home values don't. And these borrowers are so strung out that even a one-percentage-point rise in mortgage rates could be enough to make it impossible to meet debt payments, pushing some into default.

How safe is it?
New Century says it picks mostly the cream of the subprime crop and that it is confident its loans will be paid back. But it has hedged itself should things go wrong. After having to write down loans in 2000, it decided not to keep most of its future loans on the books for long. So it started selling a lot of loans to Morgan Stanley and other investment banks. These buyers, paying $1.04 now per $1 in loan face value, don't hold on to the loans, either. They bundle the loans into securities and sell them to insurers and other big fixed-income buyers for an even richer price.

Why such hot demand? With Fed funds rates at a 45-year low, where else can fixed-income investors get yields of 8% to 10%, unleveraged?

Richard Eckert of investment bank Roth Capital Partners is a New Century bull, but even he's worried. He says that rising interest rates will eventually take a lot of these borrowers by surprise, leading to foreclosures.

"At some point they won't be able to refinance again, and that will set off a domino effect," he says. "More and more loans will go bad, lenders will pull back, and the consumer won't spend as much."

© 2012 Forbes.com

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Data: Latest rates in the US

Home equity rates View rates in your area
Home equity type Today +/- Chart
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$30K home equity loan FICO 5.26%
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