Why I'm Glad I Moved to Staten Island: Mortgage Defaults on the Rise

It looks like we may have dodged a bullet when we were priced out of Ditmas Park. In early 2005, we ended up in a bidding war over a beautiful yellow Victorian house on Rugby Road. CvB's imagination was irretrievably captured. The agent we were dealing with at the time, Eileen Gallagher, knew our absolute price ceiling and kept asking us to submit our best bid. She reassured us that any reasonable offer would be entertained, and that we still had a chance. Our most outrageous, imprudently overextended bid ended up being a good $500,000 shy of the eventual sale price, which tells you what kind of froth we are talking about. For just the difference between the bid and sale prices on that house, you could just about buy a large Victorian house in our neighborhood.

That was the moment we gave up on Ditmas Park, turning instead to Crown Heights, Jersey City, and ultimately, Staten Island. At the time, I consoled myself with the idea that it was the reckless loan market that made unreasonable sales like that possible. What's more, the mortgage numbers I was being approved for weren't at all numbers I'd have been able to pay if I wanted to have money left over for chewing gum and heating oil. Even with interest rates as low as they were at the time (5% for fixed and 4% for variable mortgages), I refused to entertain the idea of an ARM or IO (interest only) mortgage in favor of a stolid 30 year fixed at 5.3%. My conservatism there was based mostly on an inkling that interest rates, at historic lows, had nowhere to go but up. A prescient commentator I heard at the time forecasted that in mid 2006, we'd be seeing a surge in the number of mortgage defaults as (1) interest-only loans went off their introductory fixed-rate periods, (2) structural economic changes made it impossible for some people to manage the outrageous payments they'd agreed to in better times, and (3) the bulk of the first 3 year interest only loans from a few years back started to revert to including huge principal payments, in some cases as much as doubling the homeowner's payments.

For example, if you had taken on a variable rate 3/30 (pay interest only for 3 years, then pay the principal and interest combined for the remaining 27) interest-only loan for $300,000 at 4% three years ago, your interest-only payment would have been $1,000 per month.

Today, however, with the interest rate up to 7% and payment on the principal also due, that payment goes up to $1,995. If you don't believe me, check out this calculator.

The bet the IO loan takers made was that home prices would continue to rise (allowing a quick flip sale for a profit if costs got too high), and that interest rates would stay low (making a favorable refinance possible when the loan reverted to including principal payments). I reasoned at the time that the combination of rising prices with low interest rates wasn't a condition the Fed was going to allow for much longer, and indeed I was right. And today's headlines corroborate the idea that the big bills are coming due for those who overreached.

According to an article in today's Wall Street Journal (wsj online is subscription only so this link is only for those who have access), "Soaring housing prices and aggressive mortgage lending have saddled home buyers with ever greater levels of debt, and early signs are now emerging that more people are unable to keep up with their monthly mortgage payments." The article goes on to say that delinquency on loans made last year grew out of proportion with the increased number of loans, and that, due to piggyback home equity loans and rampant refinancing, 29% of borrowers who took out loans last year have no equity in their homes. What's more, with interest rates continuing to climb, delinquency is expected to continue to rise, culminating in a glut of defaults in 2008, when "some of the most aggressive loans made last year might experience their biggest problems." Mortgage lenders interested in maintaining the pace of the housing market that made them rich are continuing to ply even applicants classified as credit risks with large loans with no concern for what will happen to the housing market when those borrowers default.

What happens, obviously, is that forclosures will flood the market as they are auctioned off by desperate banks for the lowest acceptable value, resulting in a stiff downward pressure on home prices. That trend, combined with a long-forecasted withdrawal of foreign investment in the dollar and the US Treasury bond markets, is what could bring about a solid drop in real estate prices. Good for home buyers and tentative buyers late to market, but bad for existing homeowners. Fortunately, because we moved to a place where even today home prices seem to be within the realm of reason, we're not especially concerned either way.