Monday, February 12, 2007

The Subprime Mortgage Default Opportunity

Subprime mortgages have been in the news quite a bit lately, and the news has not been good for subprime borrowers and people who own stock in subprime mortgage lenders. For those of us in the market to buy a home, however, I think the news is actually very good.

If you have a high credit score, you can usually get a mortgage at a pretty good interest rate, let's call it somewhere around 5.8% for a 30-year mortgage today, according to However, if you have a low credit score, you are considered a risky borrower, and must therefore pay "subprime" rates sometimes well in excess of the 5.8%.

During the housing boom of the past 5-10 years or so, many people with shaky credit histories, low incomes (as compared with their mortgage payments), and low credit scores were able to borrow money to buy houses as banks relaxed their guidelines around granting loans to these "subprime" credit risks. They used tools like adjustable rate mortgages, interest-only mortgages, and other creative kinds of financing to get people into their homes (or to buy them their investment properties).

This was all well and good in the low interest rate environment we've enjoyed for a long time, but as interest rates have come up over the past few years, these shaky buyers have been increasingly unable to make their mortgage payments and going into default.

The big news that put subprime defaults on the map recently was HSBC's profit warning, where it said that it was going to increase its provision for loan losses by 20%. This warning was followed by others, all of which blame increasing subprime loan defaults for unexpectedly poor results.

Dan Green over at The Mortgage Reports Blog has been following the news and even created a category- subprime shakeout - on his blog for the related news.

I have been silently cheering a housing market decline for the past couple of years because I recently got married and have been saving money to buy a house. With the way the market has overheated, it became clear to me that I would never be able to afford one (especially in New York) unless prices came down. Like a lot of people in the USA, the housing boom simply priced me out of the market.

Mortgage defaults may be a good catalyst to drive prices down. As people realize they can't make their monthly mortgage payment, one of their options is to sell their house and try to use the proceeds from the sale to pay off the mortgage. They truly become "motivated sellers" and will make price concessions to get the house sold so they can stop hemorraging cash via large monthly mortgage payments. Home prices are usually based on comparable sales, so if one home in a neighborhood is sold at a "below market" price, the price tags on other houses in the neighborhood will usually come down as well. This could present a great opportunity to buy a home for a decent price.

Now before you villify me for cheering a housing price decline, let me clarify a point here. I'm not hoping that families are put out on the street. That is the last thing I want. Instead, I want to see speculators and investors leave the market.

I think a big cause of the housing boom was investors buying second and third homes as speculative properties, hoping prices would go up and planning to "flip" the homes for a quick profit. I personally know some people who did this and these people are currently sweating bullets because the quick profit did not materialize. Instead, the value of the homes and condos they bought have actually declined, leaving them stuck with adjustable mortgages bearing rates that are moving higher and higher. If they sell, they will realize a loss, but that is a risk and it is all part of the game they were playing.

At any rate, for all of us who have been hoping to buy a home, but felt hopelessly priced out of the housing market due to speculative excesses, we can let out a silent cheer each time we see a subprime mortgage lender report that defaults are rising. As the motivated sellers run for the exits, we will be there with open arms, ready to take the home off of their hands for 20% down and 25% off of the asking price. We just need to be ready for the opportunity.

I'll leave you with one of Warren Buffett's mantras for investment success: "Be greedy when others are fearful, and be fearful when others are greedy." I am in no way a real estate expert, but I think the next few years might offer some opportunities to be greedy in the housing market.

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