It's Time To Regulate the Subprime Loan Business

by: Faisal Laljee

As if there isn't enough talk of the subprime mortgage business already out there, here is another post concerning the subject. Why is this post different than some of the others? For one, living in Los Angeles means I have some friends in the mortgage arena so I know a thing or two about the business, and for another, the investor side of me presents the other side of the coin.

What is Subprime?

So what's the problem in subprime? To understand that better, lets start with the question "What is subprime?". Every lender has a different criteria for subprime but mainly, people with Poor to Good credit are considered subprime. Usually, this translates to a FICO or a box score of between 500 and 700. Some lenders have prime mortgage products for those that have a credit score of 640-700, but for the most part, this area is considered Alt A, which means prime product for a subprime borrower. For a business, subprime loans are risky in that they have a higher tendency to default, however, these loans have higher profit margins.

Companies like Ameriquest and New Century (NEW) have made a lot of money over the recent years taking advantage of the housing boom by lending to riskier consumers and making the higher margins. When consumers were not able to afford the monthly payment, they offered Negatively Ammortized loans, 120% loans and other such irresponsible loans against Stated Income without any regard to the long term impact of these to the borrower, the industry and the government.

From 1998 to 2005 when the residential real estate market was expanding by leaps and bounds and property values appreciated as much as 30% annually in some markets, subprime borrowers who bought a house enjoyed their home equity by refinancing multiple times in a year to get cash and either pay off their higher interest credit cards or finance their home improvements and/or other purchases. Lower rates meant their payments were stable even as their borrowed loan amount increased. It really was a rosy picture.

Did you know that over the last 50 years, the average annualized gain in the housing market has been 3%? Compare this to the double digit gain over the last 10 years and it is no surprise that housing has not been an investment vehicle until recently.

What is the Problem?
So why is there a problem now? I don't believe the problem is subprime specific. After all someone who has a score of 710 and qualifies for a prime loan can easily slip to 690 within months. In fact, prime ARM delinquencies are at 6 years highs, whereas fixed rate subprime mortgages are well below their highest levels. So regardless of who you are on the credit spectrum, the increasing interest rates since 2005, declining property values since 2006 and the expiring ARMS (adjustable rate mortgages) has impacted borrowers.

ARM payments have jumped anywhere from 10% to 50%. There is no more equity left in their home since they refinanced at higher prices, which have since declined. Loan to Value ratios for many such borrowers is over 100%. This means the banks own their homes and the borrowers still owe these banks money on top of that.

You have a consumer who makes average income, lives beyond his means, has used up every ounce of his home equity to finance items he couldn't have afforded otherwise and now he is looking at an increased monthly payment, higher rates on his credit cards resulting in higher minimum monthly payments to creditors, and a home that is worth less than the amount he has borrowed to finance it. All this against flat to slightly higher wages.

This situation is compounded in states like California whether median home value as of 2005 is $524,000. Such mortgages run around $2500 per month these days even for people with excellent credit. Considering property taxes, home owner's association, gas prices, car payments and other expenses, such a person needs to make $100,000 a year before taxes ($6000 per month after taxes). Median income before taxes in California is $49,894 as of 2005 according to the US Census Bureau. This means that most people cannot afford the house they live in. While California is an extreme example, other states are not too far behind.

Who is at Fault?
It is partly the lenders and partly the borrowers. That is the general consensus, but I think the government should have stepped in a while back. Alarms had been raised time and again about the looming disaster that has finally hit us today.

The lenders are at fault for lending to borrowers who could have been identified as being high risk. But then lenders are in the business of making money even if its at the expense of the consumer. Or are they? If they are public companies then yes, their primary obligation is to their investors. When rates went up these lenders loosened their underwriting standards to attract a shrinking pool of borrowers instead of tightening in the face of lower home values.

The borrowers are at fault for being over-extended. Greed for cash in the face of rising property values got the better of them and they kept spending borrowed money even as incomes didn't rise.

The government is at fault for not taking action earlier. By generalizing across the country, I am being unfair to some states who have adopted aggressive policies to protect home owners. Let me clarify that I believe this is a Federal matter and as such individual states should not be entirely responsible.

So what action could the federal government have taken? More importantly, should they regulate the mortgage business? After all, they regulate banks and most of the banks have a mortgage division.

The answer is yes. Mortgage lenders should be regulated somewhat. Certain strict underwriting criteria should be enforced on all lenders so those borrowers who cannot meet this criteria cannot borrow. Additionally there should be a cap on how much can be borrowed. This cap can be based on past income, current income and current debt. Unlike existing rules, only documented income (in the form of taxes and pay stubs) should be counted.

Retirement accounts, savings and investments should also play a role but should not be categorized as income. These are safety nets and should be treated as such. Most lenders have these underwriting criteria but they are self-regulated and often bend the rules to get these loans approved. New Century is a prime example. The Office of Thrift and Supervision that regulates banks should have a separate division to handle non-bank lenders.