Subprime Borrowers Will Return to the Marketplace (Part 2)by Keith Gumbinger
We postulated not long ago in this blog that the subprime mortgage markets — one of the causes of the mortgage market meltdown — will re-emerge. What we don’t know is when that will actually occur, but we remain convinced that it will.
There are a number of factors which support the return of the subprime market.
First, the economic downturn is creating a new class of borrowers who are having trouble paying their bills on time. This is not only true in the case of mortgage loans; delinquencies are rising for virtually all kinds of credit. Late payments do eventually drive down credit scores, and a vast number of formerly good-credit-quality borrowers are now — or will eventually join — the ranks of a growing number of Americans who no longer qualify as “prime” borrowers.
The increasing emphasis on tightening underwriting standards — the raising of the credit bar — means more Americans are slipping into “near prime” status already. Formerly, a FICO score of perhaps 650 was considered “good” credit (with over 700 “excellent”), but those numbers are more like 680 and 720 now. At the moment, these borrowers can get loans, but the risk-adjusted price of their money is increasing over time.
Second, the new subprime market will be an untapped reservoir of new business with little competition, at least initially. Savvy investors or investment firms will re-discover a ready audience willing to pay above-market yields simply for access to credit.
It’s worth noting that much of the risk of investing in subprime mortgages has more than one component. Obviously, there is the risk that a borrower with a history of not making payments on past loans will decide to not make payments on the next one, too. However, that’s a known risk, and certain safeguards can be put into place. Perhaps the greater risk — at least the one which has caused the most damage to date — is that the value of the asset against which the loan was written can decline so far and so fast that it not only overwhelms any possible hedging strategy, but that it also wipes out the hope of recovering even a majority of those lent funds.
That being the case, the crucial criteria in rebuilding a subprime mortgage market is stabilizing, and ultimately increasing, home prices. If investors believe that certain risks can be managed, and that recovery of invested funds is at least possible, they will probably find some new appetite for higher-yielding mortgage risk.
A third consideration may be “affordable housing goals,” those broadly-defined government initiatives to help promote homeownership. At least some portion of “affordable” mortgages contributed to the mortgage mess in which we find ourselves, and with the ranks of the un- and under-employed growing daily, efforts and initiatives to again “help these people” are certain to follow. Some such initiatives already exist in the case of loan modification and refinance plans, and arguably in the form of “cramdowns,” all with the intention of helping people stay in homes they can no longer afford without extraordinary intervention.
After all, what was the subprime market if it wasn’t a way to help promote homeownership to the underserved, credit fringes of society? There’s a good reason why the homeownership rate went up to record levels over the past few years (only to have started receding lately).
Fourth, if our long history in this business has taught us anything, it’s that the market tends to make certain of the same mistakes over and over again, all under the guise that “this time it will be different.” Negatively-amortizing short-term ARMs? They date from the mid-1980’s; rates went up and that ended badly. Low- and no-doc (lately known as Alt-A) loans? The experience of those back in the late 1980’s/early 1990s nearly broke several major mortgage lenders, and the losses on them were among the proximate causes of the “credit-crunch-led” recession of that time. Subprime loans going sour? See 1997-1998, when billions were lost in bets on poor credit quality borrowers at well-above-market interest rates. High-LTV loans? Been there, done that: anyone remember the 125% – 135% – 150% home equity lending craze during the mid-late 1990s subprime boom?
Add those together, mix in a refi wave which flushed cash into the market and pushed default rates down to record lows, spiraling asset values and put them into a number of securitizing machines running flat out… you get — once again — all of the ingredients for another boom-and-bust cycle. So shall it be with subprime lending. If history is any judge, about the only thing that will change will be what it’s called next time.
The next boom probably won’t take the same shape as the last one, probably won’t go as far in terms of liberal underwriting standards (we expect that new regulations will take care of much of that), and will likely include counseling requirements for borrowers. Still, we have no doubt that as long as there’s a willing, untapped audience and the never-ending search for higher yields, it will come.