But Is Subprime Really the Issue?

by: Average Joe Investor

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.

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