Living in Interesting Times For Subprime

“May you live in interesting times.”
–Originally attributed to an ancient Chinese curse

In 1966, Bobby Kennedy made a speech in South Africa in which he quoted the famous line about interesting times, attributing it to an ancient Chinese curse. Chinese scholars have been unable to find its source in their culture, and think it may have origins in either America or England. Regardless of its source, it is apt both as a blessing and as a curse. The “interesting times” of recent years has enriched lenders, brokers and everyone else along the value chain of mortgage origination. But the times are interesting today for a less happy reason: the subprime party is over and it is time for someone to pay the bill.

It’s all about growing up. When you are young and irresponsible, it’s not surprising when you do things that might embarrass a more grown up person—unless of course you happen to be in Las Vegas, where what happens there, stays there. The subprime industry has been on a bit of a bender over the last few years, and Wall Street is playing a parental role in sobering things up. To illustrate just how interesting the times have become, consider these sound bites from single story in the Mortgage Ledger:

• Investment banks are routinely incurring losses on subprime and low-documentation loans, resulting in unprecedented numbers of loan repurchases by lenders.
• Lenders are having to restructure their loss reserve strategies to allow for repurchases on problem loans, sapping profits. NetBank added $13.2 million to its loss provision expense in a single quarter. Fremont General Corp. repurchased $238.4 million during the second quarter of 2006, more than twice the level of repurchases in the previous quarter.
• H&R Block added $11.6 million to its reserves, based on experience with buybacks caused by early payment defaults. A related story cited an H&R Block press release stating that it expected to “record a $102.1 million provision for losses in the current quarter related to its subsidiary Option One” to reflect an increase in loan repurchases caused by early payment delinquencies.

It’s not just Wall Street noticing an ugly trend in the subprime world. The New York Times, citing an MBA report, noted in September that, “The rate of subprime ARMs — representing lending to people with poor credit histories — that were entering foreclosure rose to 2.01 percent, the highest since the fourth quarter of 2003, the report showed.” Growing pains for subprime, or death throes? Clearly the capital markets are becoming fed up with the noise from the party downstairs, and have decided it’s time for the market to quiet down a bit.

As a point of order, the term “subprime” really isn’t applicable any more, as the segment no longer deals solely with below average credits. Alt-A and Alt-B are in the mix, along with stated and other low-doc programs that aren’t credit score-dependent. Things became fast and furious there for a while, but thankfully we never got to the ultimate program an industry wag predicted would be upon us: the “stated FICO” loan. Think of the market segment not as subprime, but as nonprime, since Wall Street tends to look at it that way.

Industry experts are concerned. Sam Marzouk, CEO of Argent Mortgage, believes that the current environment is a natural evolution of an industry fueled by competition. “What we’ve seen in the last few months is lenders adopting various strategies to address challenging market conditions,” he says. “But the changes in the market go beyond current market conditions. The non-prime market is fundamentally changing—it is maturing.” A good word, maturing. And it is happening at a good time. “As the market continues to mature and margins become thinner,” he continues, “it is the low-cost, high-quality producer that will be successful. Companies that are able to use technology and other innovations to drive efficiency and service are going to be the winners in the new, more mature nonprime market.”

Look for lenders to offer a variety of new ways of doing business involving new technologies—not overly-aggressive loan programs that end up being of no good to anyone, including borrowers. Among these technologies are document management systems and other ways to reduce paper handling in the process, coupled with automated workflow, Internet portals and continuing advancements in automated decisioning capabilities.

Many industry leaders believe the core problem is in early payment defaults, often but not always an indication of borrower fraud. Howard Wegman, CEO of CreveCor Mortgage in St. Louis, Mo., notes, “Previous to the last six months, investors might find one or two EPD loans (in a pool) to push back to the lender, but today we see 10 to 15 at a time. This type of strain on the capital markets will eliminate a lot of mid-level producers.”

Debbie Rosen, immediate past-president of the National Home Equity Mortgage Association (NHEMA) and one of the nonprime industry’s best-known executives believes part of the problem is a result of lenders trying to accommodate marginal deals. “Common sense tells you that repurchases would not be an issue if loans were underwritten in perfect alignment with lender guidelines,” she observes. “I believe that in a strong market, lenders may think that volume covers a few mistakes and might tend to overlook some of what might be considered ‘minutiae.’ When markets change and delinquency, fraud and credit risk increase, every loan is scrutinized more closely, thus loans that may have sold and survived in pools are now being kicked to the curb.” She feels that the best way to avoid the buyback environment that has cost big mortgage banks hundreds of millions of dollars is for lenders to make good guidelines and use them. “We are in an environment where loans have to be perfect,” she explains. “The critical issue is fully documenting your underwriting guidelines. If your underwriting guidelines claim you only make loans up to 95 percent LTV, then you cannot make a 96 percent LTV loan, there is no wiggle room. And make certain you have a process to ensure that appraisals are sound—don’t cut corners on the appraisal. At the end of the day the driver behind a nonprime loan is (the property’s) value.”

So brokers can expect to see less flexibility in the more mature environment when it comes to accommodations and exception handling. Jim Buchanan, Wells Fargo’s national sales manager for its Wholesale Alternative Lending Division, echoes that expectation. “We adjust credit criteria as needed to balance risk, responsible lending and our desire to be competitive. Risk management and responsible lending rule at Wells and we all agree on that. If Lender “X” wants to walk over the edge, we’re not going to be holding their hand.”

Are we in a “flight to quality” in the nonprime space? “I certainly hope so,” says Buchanan. “We want to keep our AAA from Moody’s and our AA+ from Standard and Poor’s.” Rosen responds to that question with, “Absolutely, but that does not mean that credit-impaired customers with temporary problems are out of luck. It means that documentation is everything.” The market has been moving away from documentation for years, offering “stated everything,” and originators have certainly used all the tools with which lenders have provided them. Expect many of those tools to disappear from the mainstream lenders, and to become far more expensive from the boutique shops that will continue to support them. Given the rising delinquencies and early payment default problems, you certainly can’t blame the lending community for backing away from those loan types. Brokers have jokingly referred to stated incomes as “liar loans” since their inception. That nickname appears more apt now than ever before, as more of them go delinquent soon after closing.

Having said that, it should be noted that there are still plenty of creative programs available out there, including Alt-B, sometimes referred to as “Alt-A minus.” It is an illustration of how Alt-A lending is inching closer to a classically subprime product, but with several notable differences. “The Alt-A product is less flexible than nonprime,” says Wells’ Buchanan. “We grant virtually no exceptions in Alt-A, as opposed to nonprime, where we are more likely to consider compensating factors.” He adds, significantly, “The capital markets drive that.” Ultimately, Wall Street drives everything, and in more ways than one, as we will see. Regarding the Alt-B product, Buchanan describes the category as covering FICO’s 600 or 620 through 660 or 680, but with stiffer guidelines than nonprime. “Our Alt-A minus program sits between nonprime and Alt-A prime,” he says. “It’s there to capture a slice of market that we might miss if we only offered nonprime and Alt-A, and gives us more flexibility in rate and credit criteria.”

Argent made that move last summer, announcing its Alt-A program at the NAMB conference in Philadelphia, feeling the need to expand beyond the dimensions of nonprime alone. As Marzouk observes, “It’s about finding innovative ways to expand our relationships with brokers,” a constant challenge in the wholesale arena. Lenders are always trying to find ways to add value to their relationships at the point of sale, and offering more products is only one approach. “At Argent, we’ve done this by expanding our product line through Alt-A and by developing innovative ways such as our broker marketing program, Argent University and our recently launched Purchasing Express program.” An interesting development, Argent University is a co-offering with MBA, making those formidable resources available to the broker community at vastly reduced costs.

Speaking of the Mortgage Bankers Association, it was announced last summer that NHEMA, the longtime trade organization for nonprime lenders, would be merged into the MBA to provide a unified voice for the industry. A decade or two ago, the organizations were poles apart in their membership and objectives. Mainstream MBA members were typically not part of NHEMA, and vice versa. Much has transpired in those intervening years to bring the interests of their members closer to convergence. “B and C” lending, later to become known as “subprime,” is now firmly part of the mainstream. If you have been in the industry more than 10 years, you probably remember the days when most brokers did conforming credit loans only, leaving the B and C stuff to specialists. No more.

The merger of NHEMA and MBA is significant for lenders and brokers alike. For the first time, nonprime lending will have the horsepower of the entire lending industry behind it, critical in these days of onerous legislation and statutes that seek to protect borrowers by denying them credit. Rosen, last year’s NHEMA president, is bullish on the merger. “The MBA has enormous industry respect and a very strong governmental affairs track record. I believe NHEMA will greatly benefit, and combining the two trades strengthens the ability for the mortgage industry to act ‘together’ rather than allowing special interest groups to fragment responses and confuse the message.” It will also bring greater standardization to credit grading, due diligence and other aspects of the lending side, as well as to another critically important aspect of the business, she feels. “It sends a strong message to the investor market,” she says. “Through unification of goals and by combining the considerable intellectual capital residing in both organizations, we are showing Wall Street and others how serious we are about responsibly serving this very large, very important market.”

And that’s critical. At the end of the day, investors will be the ultimate arbiters of what makes a “sensible” loan, based on the ultimate indicators of success: loan performance. If they don’t pay, they don’t stay. As CreveCor’s Wegman puts it, “I think Wall Street is deciding as we speak what makes sense. Thinning margins and less demand make everyone sit up and wonder how we got in this position,” a position he describes as “self-inflicted.” Having closer ties with the capital markets is a good thing, he feels. “I believe today there is better communication between The Street and lenders, which will help build a better and steadier platform for the future.”

Experienced mortgage originators will agree that “steady” is a good thing, as long as the market keeps the ability to create new programs to meet new needs. Wall Street has historically “gone along” with most new programs the industry has created, but has taken a lot of shots over the years from programs that didn’t perform as expected. Gray-haired lending types were scratching their heads years ago when the 125 percent LTV loans were hot because those loans went counter to their training, but the Wall Streeters soldiered on until the delinquencies soared and the programs were dumped. The “stated era” has probably run its course by now, at least when low FICOs are involved.

The most historic recent development is the decision by the capital markets to get closer to the point of sale than ever before. Wall Street firms are spending like sailors on shore leave, buying mortgage banks right and left. This consolidation, most recently including upper-tier firms like Saxon, National City and First Franklin, is widely viewed as a good news/bad news scenario by mortgage bankers. In some respects, it is cutting out the middleman between the originator and the investor, but it is unlikely the consumer will benefit through lower rates. It is more realistic to expect that the investment bankers will simply pocket the mortgage banker’s share of the transaction. Still, it is reasonable to hope for greater stability in the marketplace going forward as Wall Street learns and understands the lending business to a greater degree. Their captive firms will presumably be less likely to let competitive trends dictate the making of loans that don’t make sense, and ultimately, that’s good for everyone.

The most feared influence on nonprime’s future is also the one that knows the least about the business—your state and federal governments. Their understandings are many miles wide, ranging from sea to shining sea, but are only a few inches deep. They respond to pressure from consumer groups and activists who feel that every lender who insists on being paid every month is a predator. To make matters more incendiary, the movers and shakers within those governments are people who benefit from crusades, from prosecution and from news conferences about their crusades and prosecutions. For many of them, it is about the votes, not what is best for consumers, and most of them don’t begin to understand the circular, self-replenishing dynamics of our capital markets system.

“Legislation will continue to increase, but if the industry handles it correctly it will be no different than in the past when regulation threatened lending in general,” according to Rosen. “We survived TIL changes and many other things that seemed onerous. The real issue in my mind is a way to simplify the process. Simplification would go a long way to help everyone believe there is not a hidden agenda to push someone out of a home.” Most will agree that our industry could use a lot of simplification, and not only to help consumers, but to provide relief from endless disclosures and processes that confuse borrowers and waste trees by the acre.

Looking astern, we see a nonprime market that would have been not just under-served a decade or two ago, but one that would have been completely non-existent. The nonprime industry has truly stepped up and made credit available to people who otherwise would never have seen their name on the mailbox out front of their own home. This has been accomplished at surprisingly little expense over and above the vanilla agency loan, and thanks to our capital markets system, the money has flowed very consistently and well, other than the occasional Wall Street bout with indigestion such as this one and the little dustup in 1998 that restructured the major industry players.

Looking ahead, we can expect a nonprime market that is a little less excited about offering hyper-aggressive products, but probably a bit more reliable and consistent. As far as future-gazing goes, Marzouk says, “Over the next 12 months, I believe the trend toward efficiency and high-quality service will continue. Lenders who can innovative, be extremely competitive on price and provide outstanding service will succeed.”

Debbie Rosen predicts that, “It will continue to be a tough market. The light will be shining brightly on credit quality, property values and margins. Affordability is key for borrowers, and as interest rates rise, consumers need products that allow them to service their mortgage debt.” Taking the theme of innovation a bit further, she adds, “The mortgage industry in the United States has been brilliantly conceived and I’m never surprised by new products. I believe they will continue to develop to ensure we provide homeownership opportunities to as many families as possible. These might include a good portable loan and a hypothecated loan allowing investments like 401ks to work as down payments.”

Buchanan sees more consolidation ahead. “I think the biggest issue is simply the market size and the hold-over of excess capacity among all mortgage players. In tough times we see irrational pricing and credit criteria, and we are likely to see more of that before we see less.” He adds that ancient Chinese curse—the one that actually might be more American than anything else, with “May we live in interesting times… but not as interesting as 1998.”

James Hennessy