Mortgage: Everything you need to know....and more!

Subprime Lending

Subprime lending (near-prime, non-prime, or second-chance lending) in finance means making loans that are in the riskiest category of consumer loans and are typically sold in a separate market from prime loans. The standards for determining risk categories refer to the size of the loan, "traditional" or "nontraditional" structure of the loan, borrower credit rating, ratio of borrower debt to income or assets, ratio of loan to value or collateral, documentation provided on those loans which do not meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages (are "non-conforming"). Although there is no single, standard definition, in the United States subprime loans are usually classified as those where the borrower has a FICO score below 640. Subprime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards. The term was popularized by the media during the "credit crunch" of 2007.

Subprime could also refer to a security for which a return above the "prime" rate is adhered, also known as C-paper.

Subprime borrowers show data on their credit reports associated with higher default rates, including limited debt experience, excessive debt, a history of missed payments, failures to pay debts, and recorded bankruptcies.

The Wall Street Journal reported in 2006 that 61% of all borrowers receiving subprime mortgages had credit scores high enough to qualify for prime conventional loans.

Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.

 

Background

Subprime lending evolved with the realization of a demand in the marketplace for loans to high-risk borrowers with imperfect credit. The first subprime was initiated in 1993. Many companies entered the market when the prime interest rate was low, and real interest became negative allowing modest subprime rates to flourish; negative interest rates are hand-outs, such that the more you borrow the more you earn. Others entered with the relaxation of usury laws. Traditional lenders were more cautious and historically turned away potential borrowers with impaired or limited credit histories. Statistically, approximately 25% of the population of the United States falls into this category. In 1998, the Federal Trade Commission estimated that 10% of new-car financing in the US was provided by subprime loans, and that $125 billion of $859 billion total mortgage dollars were subprime.

In the third quarter of 2007, subprime ARMs only represented 6.8% of the mortgages outstanding in the US, yet they represented 43.0% of the foreclosures started. Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.

Subprime lenders

To access this increasing market, lenders often take on risks associated with lending to people with poor credit ratings or limited credit histories. For example, they would lend money to consumers that have bad credit. The FICO score indicates to the lender the rate of default. Those with credit scores below 620 have a much higher default rate than those with credit score above 720. However, if a borrower has sufficient income then he or she may qualify for a subprime mortgage product. Subprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many subprime loans, this risk is offset with a higher interest rate. In the case of subprime credit cards, a subprime customer may be charged higher late fees, higher over-the-limit fees, yearly fees, or up-front fees for the card. Late fees are charged to the account, which may drive the customer over their credit limit, resulting in over-the-limit fees. These higher fees compensate the lender for the increased costs associated with servicing and collecting such accounts, as well as for the higher default rate.

Borrower profiles

Subprime loans can offer an opportunity for borrowers with a less-than-ideal credit record to become a home owner. Borrowers may use this credit to purchase homes, or in the case of a cash-out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down on a high-interest credit card. However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates, increased fees and other increased costs. Subprime lending (and mortgages in particular) provides a method of "credit repair"; if borrowers maintain a good payment record, they should be able to refinance into mainstream rates after two to three years. In the United Kingdom, most subprime mortgages have a two or three-year tie-in, and borrowers may face additional charges for replacing their mortgages before the tie-in has expired.

Generally, the credit profile keeping a borrower out of a prime loan may include one or more of the following:

  • Two or more loan payments paid past 30 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months;
  • Judgment, foreclosure, repossession, or non-payment of a loan in the past;
  • Bankruptcy in the last 5 years.
  • Relatively high default probability as evidenced by the credit score.
  • Accuracy of the credit line data obtained by the underwriter.

Private label credit

In the USA, this group of credit companies includes major banks such as Wells Fargo, CitiBank, GE Credit, Household Finance, and more. While it is not certain what percentage of subprime lending involves the private label branding of the retail chains, most national retail chains use some form of subprime lending as a marketing strategy. Deferred interest programming may result in high default rates that must be offset by aggressive lending practices. It is common for a $200,000,000 furniture retailer to have 50% of their long-term business be derived from the direct result of private label credit promotions.

Origination, securitization and servicing

Some subprime originators (mortgage companies or brokers) formerly promoted residential loans with features that could trap financially naive, low income borrowers into loans with increasing yield terms that eventually exceed borrower’s capability to make the payments. Most of these loans were originated for the purpose of selling them into securitization conduits, which are special purpose entities (REMICs) that issue residential mortgage-backed securities (RMBS), bonds, securities and other investment vehicles for resale to pension funds and other fixed income investors. The same process takes place for some commercial mortgage-backed securities (CMBS).

Some of these mortgage originators are owned or controlled by major financial institutions which provide a "Warehouse" line for their lending. For example, First Franklin was owned by Merrill Lynch and WMC was owned by GE. These financial institutions then remain in control of these loans as "Trustee", "Servicers" and "Controlling Class" of the REMIC trusts in hopes of deriving significant fees and other income from management of Taxes, Insurance and Repair Reserve Funds required by the terms of these mortgages.

In most cases, should these loans default, the servicing is passed to "Special Servicers" who derive "Workout", "Foreclosures" and Real estate owned (REO) management fees. The Special Servicers are directed by "Directing Class" or "Controlling Class" which comprise of majority holders of the lowest class of REMIC Trust securities also referred to as "First Loss" or "B-Piece" holders.

The shortfall of loan repayment is usually repaid as a result of "Repurchase Demand" by Special Servicer on GSE or loan seller to REMIC Trust also called "Loan Depositor." The purchased collateral at auctions by Special Servicers are referred to as REO properties which then can be marketed and sold for market value. Special Servicers usually keep the "Upside" or difference between auction price and market sale of the collateral. These foreclosure fees and REO income form a major incentive for Servicers to purchase the "Servicing Rights" of the REMIC trusts from Trustees who, depending on the terms of the Pooling and Servicing Agreement (PSA), have the authority to replace Servicers. It is not uncommon for a predatory Servicer to pay millions of dollars to procure the "Servicing Rights" of the REMIC trusts in hopes of successful foreclosures and equity stripping from Borrowers, Guarantors, Loan Sellers and Investors.

REMIC Trusts are "Passive" or "Pass-Through" Entities under the IRS code and are not taxed at trust level. However, the bond-holders are expected to be taxpaying entities and are taxed on interest income distributed by the REMIC trusts. REMIC trusts are forbidden from any other business activities and are taxed 100% on any other income they may generate which is referred to as "Prohibited Income" under IRC 860 Code.