Tuesday, July 13, 2010

Subprime Lending is Dead; Long Live Subprime Lending?


The lending market needs subprime mortgages. Yes, you read that right: our country, perhaps now more than ever, needs access to loan products for those with poor credit profiles. After all, more of us than ever before are now subprime credit risks.

New data released today by FICO Inc. show that a whopping 25.5 percent of consumers now have a credit score of 599 or below. That’s a market of more than 43 million people, and growing every day, too—thanks to unemployment levels that appear set to remain painfully high for the next five years.

This is the definition of growth market, too: historically, only 15 percent of consumers have found themselves with a credit score below 600. Now, a quarter of consumers fit the profile.

All of which underscores a unique irony to the financial mess we’re now in: much of the growth in demand for mortgages in recent history came out of the subprime sector, now thoroughly villianized and vaporized. Subprime mortgages represented between 8 and 15 percent of total origination volume between 1995 and 2003, according to data published by Inside Mortgage Finance.

These days, it’s closer to zero percent if it’s anything at all. Wells Fargo (WFC: 27.69 +2.33%)—the nation’s largest mortgage lender, year to date—said last week that it was shuttering its subprime operations and laying off as many as 3,800 employees. There isn’t a public market for subprime debt; banks surely don’t want to hold subprime credits on their balance sheet and explain such a strategy to shareholders; and the private mortgage securities market is still in what could best be characterized as critical condition. (Any private RMBS issuances seen in mortgages this year are primarily pristine credits, not subprime.)

Are we really prepared as a country to say, then, that a full quarter of all consumers—in a period of flat to declining wage growth, for those lucky enough to have jobs right now—simply don’t exist insofar as mortgages and credit cards are concerned? What if that number reaches 30 percent of consumers (and it will)?

Let me play devil’s advocate for a minute. Maybe we do need to accept the fact that a quarter of consumers shouldn’t really be consuming all that much; that’s an austerian viewpoint if there ever were one, but it is certainly true that consumers ended up way over their heads in debt and are still deleveraging household balance sheets. Much of that deleveraging, by choice or otherwise, tends to affect credit scores adversely.

That said, subprime lending existed as a viable market for years ahead of this mess, albeit with a risk profile akin to what you’d actually expect from subprime borrowers—default rates six times or more beyond what would be seen with prime credits. Only when a number of economic and market forces created an unsustainable housing bubble did we begin to see default behavior of subprime borrowers start to more closely mimic that of prime-credit borrowers—as those with debt management problems were often able to avoid reality by refinancing early and often.

The result was that subprime debt tempted investors with a too-good-to-be-true combination: impossibly high yield, especially in first-loss positions, mixed with default rates that were next to nil. Sure, voluntary prepayments are more of a risk with subprime product (borrowers with lower credit scores are typically more sensitive to interest rate movements)—but voluntary prepayment behavior has long been well understood by investors and frankly was easily hedged, or at least incorporated into trading strategy for subprime securities.

All of which is to say that subprime lending wasn’t always the villain it’s now being made out to be. In fact, back in 1999, when subprime lending was just firing up its engine, most of the consumer lobby was backing research highlighting “unequal access to capital” for those with poor credit; the Congressional lobbying machines were pushing lenders to make more loans to borrowers with weaker credit, and lenders were in turn touting their partnerships to lend to low- and moderate-income families.

I wrote about this issue way back in 2008, in a column called “Mortgage Mess Generates War of Entitlement”—it’s perhaps more apropos today than it was when I first wrote it, so I’d recommend reading it again.

Today, the tables have turned. Consumers are raging against high levels of default, and lenders are touting their successes in preventing foreclosures.

With so many consumers now stuck in the subprime credit bucket, and their numbers growing by the day, it’s really just a matter of time until the pendulum of public opinion swings back again towards wanting consumers to have access to credit. The very same organizations now harpooning lenders for predatory lending practices—rightly or wrongly—will begin calling for the banks and other lenders to make credit available to this group.

Oh, the irony of it all.

Much of our nation’s public policy is determined by the will of the voters, after all, and our Congressional representatives do tend to vote the will of people (short-sighted though the people's will may be). And if 25 percent of our nation’s consumers—ahem, make that voters—are now subprime credits, something tells me it won’t be long until even subprime consumers decide they ought to be able to buy something.

The only question left to answer is: just who will be there to lend to them?

I am an actual person so if you are interested in refinancing you can receive real time quotes and payment options by calling me directly. You can reach me, Gene Neal at 877-276-6400 Ext 101.