But Is Subprime Really the Issue?

At this point, the word "subprime" has practically become a four letter word. Mention that word, or any of the companies like New Century, Accredited Home Lenders (LEND), and Fremont General (FMT) that were at the forefront of subprime lending over the past few years and you're likely to draw disgusted looks from people on the street. But I think all the derision begs a question: is there something inherently wrong with subprime lending?

In short, my answer is no.

The broad definition of subprime loans are loans that are made to borrowers that have less-than-perfect credit. These are people that perhaps have a high level of debt already, have a habit of missing payments on other loans, and perhaps even have defaults or bankruptcy in their past.

Lending to this group is obviously much riskier than lending to someone who has little outstanding debt, perfect payment history, and a wad of cash in the bank. However, that risk is studied and in order to take on the incremental risk, lenders charge higher interest rates. The idea is that when everything shakes out over time, the lender will have more defaults/foreclosures, but that will be balanced out by the higher rates that the rest of the group pays.

There is most certainly a market for these loans, and as long as risk is adequately measured, there is no reason that there shouldn't be someone out there serving this part of the market.

The problem currently, though, is that lenders had not adequately cushioned themselves for the default risk that they were going to face. Historical measures of subprime default risk were used at a time when the environment and the loans being made were anything but similar to historical subprime lending. Housing prices were soaring, people were falling over themselves to buy homes, and subprime loans were being made with various features that completely changed the risk profile of the loans.

Now there is a lot more that I can get into here, but I wanted to just briefly focus on what I see as the key issue that has made the word "subprime" sound like "Long Term Capital Management" -- namely, the availability of 100% financing.

I have no problem with 100% financing when you're talking about a big screen TV or maybe a nice sectional, but 100% financing for a home is asking for trouble if you ask me. Even worse is allowing subprime borrowers to use 100% financing. Of course, I'm not just talking about full 100% loan-to-value [LTV] loans, the same applies to the so-called piggy-back loans that provided 100% financing through 80/20 or 90/10 paired loans. And don't even get me started on 110% LTV loans...

Give somebody -- anybody, not just somebody with bad credit -- the ability to buy an asset without risking any of their own money in a highly speculatively environment, and you're asking for them to walk away from the loan if things turn sour.

Coming back around to my original point, though, there's no reason why subprime lending has to disappear. Right now the market has tightened like a vice on those loans and I can guarantee that there is demand just building up -- demand that somebody can and should be serving. It's just crucial that lenders are responsible in how they make those loans and how they project the performance of those loans.

So should subprime go away? Nope. It just needs a little resuscitation and a maybe some plastic surgery to get back on its feet. And given how risky people perceive those loans to be right now, whoever wants to step in and serve that demand should be able to get more than adequately compensated for it.

Comments

[Rich4REITs:]

This is the best article ever read after subprime devastation. The problem is not subprime since it's designed for people need that. However, it's because of greedy of financial market.

2007 Aug 31 01:27 AM

[mortgage br...:]

the problem was wall street mis-priced these subprime loans and thus didn't have a big enough equity trauche to absorb these higher defaults that are now likely to be happen. Granted if they had priced it right not nearly as much product would have been created, thus their underwriting fees would have been greatly reduced. See how this works.............

2007 Aug 31 10:04 AM

[emily x:]

"The broad definition of subprime loans are loans that are made to borrowers that have less-than-perfect credit." -- True, but incomplete: the kinds of adjustable-rate loans that are causing all the trouble were originally designed for people with high incomes who needed short-term financing. These loans should never have been offered to people w/ doubtful ability to repay. And I agree completely that "lenders [have] not adequately cushioned themselves for the default risk that they were going to face." The whole thing is just a giant, collective sticking of the head in the sand.

2007 Aug 31 10:05 AM

[Sr. Pessimist:]

Good point. Financial opportunities are largely inherited, anyway. A boss will hire a foreign visa worker, then fickly "let him go" during the probationary period, or will hire a newcomer, and then fickly "let him go" during the probationary period, but will never fire a friend of his that maybe can't do the job if it weren't for the chain of overworked newcomers he fires one after another during each of their probationary periods (presumptious illustration).

Maybe things were unfair to somebody and they couldn't get it lined up right without a decent bank loan? After I got fired from my web programming job in tech via politics, I had no idea what to do but to live on loans until I got my expected windfall. Without banks stepping up, I would not be in a position to deliver 8 businesses to any economy. I could have been dead, a completely wasted tech talent doing nothing for anybody. But now, after living on credit cards and my windfall, my tech skills are going to do some good for myself and others. That's "subprime," if you look at the numbers. I never failed a payment, but I surely had some debt when taking on loans. I may have been Alt-A, actually, but I surely didn't take out loans I had no use for.

This lending here will pay off, and will make up for quite a few borrowers who don't.

2007 Sep 03 01:11 AM

[irondoor91:]

Am I sub-prime? We built a home in a small northwestern US town after moving from a large metropolitan area in 1998. Total cost = $330,000. Fixed rate 30 yr mortgage = $260,000 (79% Loan-to-cost).

In late 2006 my consulting business revenue took an unexpected hit, and we needed a cash cushion. Solution? A 70% LTV 30 yr fixed at 6.5% (Interest-Only for 5 yrs) plus a HELOC up to 90%. Our credit score is 730+.

Our home appraised at $911,000 (annual rate of growth = 11.94%). Total cash out = $797,000. After paying off the first mortgage and some other higher-interest debt we have $480,000 cash in the bank and liquid investments. With newly generated revenue from the business plus investment gains/dividends/intere... I believe that we have a 5-7 year comfort time-frame.

We send all cash flow from the business and investments to the HELOC and pay all bills from it. Any excess cash flow pays down the HELOC and from time to time we make principal reduction payments on the first mortgage.

Our loans were on a stated income basis, thanks to which we were able to continue with business development and remain in a stable environment. However, due to the on-going mortgage and housing related "crisis", I am sure that we would not be able to obtain this same financing today and the home would probably appraise at least $100,000 lower.

These loans were "Alt A" and are very useful to a particular class of borrower: the reasonably successful self-employed small business owner who uses his residential equity for business financing. Most are not be able to obtain working capital from traditional lending sources, expecially if the business is "consulting" and actually has no physical assets other than the borrower's knowledge and experience.

These loans are, however, toxic waste for the high-risk individual who uses them for further real estate speculation. For those who have done so, the illiquidity trap has been sprung.

2007 Sep 03 12:21 PM

[daShark:]

In my opinion, the most dangerous aspect of the subprime debacle is not the cost to the deluded, misguided ninja borrower, nor the impending collapse of home builders, roofers, drywall installers, Weyerhauser, plumbers and electricians, carpenters, and real estate agents who make the majority of their incomes outfitting new construction, or selling existing and new homes, but the
extremely dangerous situation set up by investment firms who knowingly "buried' these cdo instruments into otherwise viable mutual funds.

China, just to mention one lone country, has invested heavily in these funds unwittingly. My fear is what will happen when they get tired of falling value, failing institutions, and begin cashing in on their holdings.

We have an M3 situation now, headed quickly for M4, which the gov't has stated they will no longer announce for fear of panic. Why would Americans panic just because we consume everything we import, instead of converting our imports to profitable exports?

One final thought is for the gentleman who stated his holdings in cash are over $400,000 in banks. Does he realize how much of his cash is covered by f.d.i.c. guarantees? Somewhere around $200,000?

2007 Sep 03 04:02 PM