Philip Gvinter

What Were Subprime Loans Modeled On?

The biggest difference between CRA and Subprime which has not been mentioned are the underwriting standards. CRA was a subsidy placed on top of FNM/FRE loans which made them cheaper in designated areas. Subprime are loans made to non credit worthy borrowers with lax underwriting standards. The fact that both types of loans were made to similar demographics obfuscates the true intent and nature of the programs.

CRA = welfare. It was meant to subsidize those considered disadvantaged in the process of becoming home owners.

Subprime lending = high risk lending.

Subprime lending when done as a niche of the overall mortgage market was still punitive in structure for the borrowers. In the 1990s subprime loans were typically used as "credit repair" loans. They were granted to borrowers who met lower than agency but still somewhat reasonable underwriting guidelines which required the documentation of income. The loans were structured to reset in rate after 2 or 3 years at which time the timely payments made on the loan should have allowed borrowers to refinance into an agency or other prime loan. These loans were indeed very profitable because they carried high interest rates and low life expectancies with a significant amount of fee income. They were done by portfolio lenders who had a major stake in their performance.

This changed dramatically with the passage of the Financial Services Modernization Act of 1999 also know as Gram Leach Blyley which allowed the cross selling of financial products. GLB which replaced the depression era Glass-Steagle Act allowed commercial banks, insurance companies, mortgage banks and investment banks to sell the full range of financial services products. This allowed the investment bankers on Wall St. to look for opportunities in markets previously closed to them. Among those markets was the subprime mortgage market. As interest rates fell and house prices rose the default rates on subprime loans declined. This allowed for these risky loans to be packaged up and sliced up into traunches the majority of which could be rated investment grade. This created tremendous demand for the underlying loans as the packaging and re-selling of these loans was highly profitable. In order to meet this demand the traditional underwriting standards in the subprime business began to be relaxed. Higher loan to value ratios, higher debt to income ratios and worst of all the use of stated rather than documented income were the tools used to entice borrowers who would not have qualified.

This created a new set of buyers who placed tremendous demand on the housing market at a pace which could not be matched by the supply of homes further boosting house prices. Everyone seemed to be a winner as more people owned homes, the value of homes went up and everyone was making tremendous amounts of money. The elephant siting in the corner that no one wanted to acknowledge was the fact that the affordability of homes as well as the underwriting standards were reaching historic lows. No one in either political party or in the influential home building and financial services industries wanted the party to stop. It is always extremely difficult to be the wet blanket who turns off the music and ruins everyone's fun.

The need for action was fairly clear in 2003 and 2004 when house prices had reached an unsustainably low level of affordability as measured by median home price to median income ratios and underwriting standards had clearly been compromised and included products like 100% financing with seller paid closing costs and no verification of income assets or employment (no doc loans.) But everyone had too much invested in the housing market bonanza to do anything about it. By 2005-2006 there were not enough borrowers willing to take on huge mortgage payments to keep prices moving up. By 2007 the poor underwriting standards lead to massive foreclosures and the price action reversed. By 2008 the leverage which the financial system had been allowed to use in funding these loans nearly brought it to its knees as default rates quickly surpassed what had been predicted using rose colored models.

Today we are still in the middle of the process as there are still several waves of mortgage defaults coming from traditional factors like job loss to the payment resets on interest only and neg am loans scheduled to take place between 2010 and 2012.