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July 15th, 2010

Borrowers, Lenders: Have You Learned Your Lesson?

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We knew it would happen. We can safely say that most of those who have followed the markets closely over the last few decades or so knew it would happen as well.

What are talking about? Lending to below-prime borrowers. Many market observers will tell you that the financial markets rarely learn from their mistakes. We knew that the credit crisis which spawned from the recession couldn’t last forever. Lenders of all stripes (mortgages, credit cards, automobiles) would have to eventually begin seeking out less-qualified borrowers to lend to. Frankly, there aren’t enough pristine borrowers to keep them in business.

Apparently, this trend (of extending credit to less-qualified borrowers) is already gathering quite a bit of steam:

Fannie Mae, seized by the U.S. government in 2008 to avert the mortgage company’s failure, launched an initiative in January that allows some first-time home buyers to get a loan with a down payment of as little as $1,000. Securities firm Morgan Stanley Smith Barney, a brokerage operation jointly owned by Morgan Stanley and Citigroup Inc., is offering some clients home-equity credit lines of as much as $2.5 million.

Credit-card issuers mailed 84.8 million offers of plastic to U.S. subprime borrowers in the first six months of this year, up from 43.7 million a year earlier, estimates research firm Synovate. Nearly 8% of loans for new cars in the latest quarter went to borrowers with the lowest range of credit scores, up from 6.2% in 2009’s fourth quarter, according to J.D. Power & Associates and Fair Isaac Corp.

To be fair, for some time now credit has only been available to the most-qualified borrowers, and some will tell you that markets have suffered because of it. While most mortgage borrowers who couldn’t qualify for loans in the private market have already made their way to the FHA (where downpayment and credit-score requirements are much more relaxed), we have heard from several lenders that too many qualified borrowers are being denied from getting new loans because of “overly restrictive lending guidelines.”

Is it time to resume lending to less-qualified borrowers?

Will Risky Borrowers Take On the Debt?

Forgetting for a minute that lenders are willing to extend credit to those who perhaps aren’t ready for new debt, what I want to know is, will these borrowers be willing to take on the added debt? Have risky borrowers (or formally risky borrowers — those who have repaid certain debts) learned their lesson, or will they once again stretch themselves thin just because the offer of new credit is out there?

According to a recent survey, Americans haven’t learned from the recession:

Many Americans are still not learning from the mistakes of the past two years according to a new survey by Harris Interactive that was commissioned by Lending Club, the peer-to-peer lender. A lot of people continue to ignore what were once touted as hard-learned credit lessons from the recession. Many have continued to carry high interest credit card debt, large amounts of debt, and do not know how to improve their credit scores. The scariest part of the survey comes when the panel shows just how uneducated [they] are on financial matters.

Too Much, Too Soon?

Perhaps what’s even more troubling about all of this is that the growing trend of extending credit to below-prime borrowers comes at a time when the economy is still on its heels. The Fed recently acknowledged that the economy is growing slower than expected, the unemployment situation remains dire and there’s no hope for the housing market in sight.

However, those willing to lend have defended their practices:

“Everyone here is very mindful of the financial disruptions we’ve all come out of and making sure we follow appropriate standards,” says Gina Proia, a spokeswoman for Ally Financial Inc., the auto lender formerly called GMAC Financial Services.

John D. Hawke Jr., chief U.S. regulator of nationally chartered banks from 1998 to 2004, said an increase in lending to less-credit-worthy borrowers isn’t necessarily bad as long as financial institutions manage the risk properly.

“What got us into this mess was that underwriting was not based on the conventional approach of a borrower’s capacity to pay,” said Mr. Hawke, a partner at law firm Arnold & Porter LLP. “The most important question becomes: Are lenders resorting to flawed underwriting practices of the past?”

Even with the reassurance from some lenders that they have learned lessons from the subprime crisis, we know that poor lending practices have again emerged (did they ever even go away?):

Forbes has learned that banks are quietly reestablishing the no-doc and low-doc mortgage market. In fact, low-doc loans accounted for 8% of newly originated loan pools as of this February, FirstAmerican Corelogic reports.

This whole question of whether or not we have learned our lesson comes down to two factors:

1. As Mr. Hawke asked, are underwriters resorting to the sloppy, irresponsible practices of the past (think no-doc, low-doc loans, etc.)?

2. Will less-qualified borrowers take on the credit (if it is presented to them) if they can’t afford it?

READERS: We would love to hear responses from both lenders and borrowers on this one. Lenders: have you begun to loosen your standards? Borrowers: Are you ready and waiting for your next credit offer?

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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