Subprime Borrowers Causing Upside Surprise: What's Happening Here?

A colleague of mine asked why in my recent articles I was not writing about subprime loans and the companies originating them. Instead, I was busy flogging Alt-A lenders like Indymac (NDE). Indymac does not need flogging itself, but rhetoric aside, I don't confuse opinions with facts, and at the time I did not have the facts on subprime loans yet.

So what puzzled me right now is the following: Why are the majority of the subprime lenders touted to be folding in February (Fremont (FMD), NovaStar (NFI), Accredited Home Lenders (LEND)) actually doing OK right now? A huge subprime lender, Countrywide (CFC), is actually doing so well that the CEO is currently unloading his shares at the rate of 10M a month. An upside surprise, to some people I spoke to, is an understatement.

To decide whether this could be irrational exuberance, yen-carry-trade, or just some day traders daydreaming to be millionaire picking out of favor stocks, I need to go to the root of the cause.

That cause is the identity of the subprime borrowers. I have heard, anecdotally, that being subprime is a privilege. Yes, you read correctly - Privilege. You were born prime. A couple of divorces and bankruptcies, and perhaps jail sentences for fraud later, and you become one. This suggests an unflattering description of an individual. But flattery does not win my investment decision, and neither does doing the opposite. I need a proof that subprime borrowers are risky, and that proof has to come in number.

First, how much do subprime people borrow?

The answer is predominantly 150-250k, which suggest to me slightly less than a prime borrower who usually borrowed 200-350k, but by not a whole lot. While not exactly mi casa es su casa, a house is a house and it costs money.

Okay. I looked at Countrywide rate sheet given to me by a friend who stopped by their branch early today near the gas station. The subprime borrower, depending on their downpayment and credit score, is expected to pay 8% or more, up to 15% in some cases. So 8% that is, then.

What's their monthly payment on a 200k balance, I ask. An internet calculator spits out $1700, give or take. So that's mortgage payment. How about food, assuming he has a family of three? Say, nachos and rice everyday, maybe $100/person so $300. Gas and energy, say really cheap $100. Phone, tv, clothing, shoes, $100. So say, $500 total non mortgage cashflow absolutely needed for a family of 3 living a subprime live in United States. That is $2200 a month!

Have I mentioned the (possibility!) of car payments? Could the subprime borrower possibly not need to pay credit cards? It is stretching the imagination at this point to say that $2200 a month is NOT the absolute minimum needed to afford a 200k loan and still not have to hunt the neighbor's pets for dinner. Therefore it is the minimum.

Okay. What is the gross income needed to support this transaction? Take all taxes to be 25%. He needs to get $2800 a month at the barest bare minimum. That is about $40k gross income a year, with not a bottle of coke for a Christmas gift to spare.

Those working in consumer finance knows, that number is not small! That is about the average US GDP. We are talking about the worst of the pile here, remember? The guy with two divorces, five job losses, three past jail sentences, and bankruptcies?

Consider any of these in case you were not convinced of the risks?

What if their rates are higher than 8%, which is pretty much every subprime soul out there? What if they bought the house in 2005 and 2006, which pretty much guarantees they need a lot of loan, 300k at least on the coast, just to get something that look like a 100-year old house?

I stopped my analysis right there and then, and concluded the following:

1. Subprime loans made in 2005 and 2006 are gone. This or that hedge funds paying pennies on the dollar will not see their pennies. Really.

2. The biggest player in 2005 and 2006 was Countrywide. My advice to you: They have issues.

3. House prices will do the one of the two: Drop 20-30% in real prices, just so people can afford them with real income. The second option: Drop 50%, so that people can afford them with real income and some savings of their own for downpayment should banks like Countrywide, Fremont, Novastar, and Accredited curtail their lending activities and limit borrowers access to cash. They can do this by simply making it so painful and embarrassing for unqualified borrowers to even apply.

Oh wait, they have already done that! Time to go.

Disclosure: none

Comments

[douglas_banker:]

I just don't get it! All these ill informed comments about an industry few including you know little about.
Lets start with the avg. income of a nonprime borrower, $71,000.00. Avg age 41, avg time on job 5 years and avg time in thier home 5 years. This is according to SMR which publishes industry statistics annually and the Mortgage Bankers Association.

The nonprime borrower has an avg credit score of 618! A just miss from prime score of 620. I don't know why the media gets so much from publishing such uniformed information. Nonprime lenders for the most part make good loans to people who can and will repay. Which is why all those nonprime loans of 2000 to early 2005 are performing better than expected. Now later 2005 and 2006 both borrowers and lenders stretched their appetites and went into an unknown area with option arms and other exotic products. In the meantime greedy borrowers using thier homes a ATMs continued to pay for their lifestyles by borrowing. Now the market slows and the equity is gone and we have panic party.

Quick lets throw gasoline on it by printing information that the sky is falling!! Lets call this what is really is -Chicken Little syndrom, but hey is the sky really falling? Maybe just weaker lenders being weeded out by a tightening market.

2007 Apr 20 01:49 PM

[k_denninger:]

Spot on.

Covered in depth - including Countrywide and others, at

This is one of my speciality areas right now. Home prices absolutely are overheated <i>and so is the consumer.</i> Proof? How about all that record interest income reported by all the card issuers? Makes stockholders real happy. What's it make YOU if you're the one who charged up your credit card because you can't refi again and your HELOC is maxed out after the third Plasma TV?

Hmmmm.....

2007 Apr 20 07:52 PM

[k_denninger:]

Oops - sorry, that's all screwed up with the links!

Let's try it again... top level blog at and the Countrywide specific hit at

2007 Apr 20 07:54 PM

[Austrian Sc...:]

Hey Douglas Banker, First this article was about sub-prime, not non-prime with includes alt-a. Second, I call BS on your average income and time on job stats, these are the lies that got these losers the loans in the first place. Third, the sky IS falling, and if you were one of these people that helped himself selling these loans, get some liability insurance.

2007 Apr 23 11:45 PM

[Chris Daly:]

So if the sky is not falling, what the heck happened to New Century (NEW)? Two months ago, they were the leaders in the sub-prime space and now they are in Chapter 11. They wrote too many bad loans and got caught by their investors.

I do, believe, however, that the tightening of underwriting guidelines at the sub-prime, prime and Alt-A levels will further worsen this real estate market. We have not seen the bottom. The issues are much broader than lending. We have inventory growing in many areas, which will place undue pressure on the market.

There will be a lot of class action suites against mortgage lenders, brokers, and bankers over the next couple years. If you have been brokering these loans, you may want to get a good lawyer.

By the way, I am a hard-equity (hard money) lender and see a lot of sub-prime borrowers who will never be able to get loans from any funding sources. For several reasons: poor credit, very low real income, no real assets, and in many case NO EQUITY [ZERO] in their homes. There is nothing we can do to assist these people even for us hard money lenders. The banks will end up taking back these homes. This is simply a bad situation for all involved.

2007 Apr 26 07:09 PM