Can subprime loans solve the credit crunch?

Could re-energize the housing market

More subprime mortgages would surely improve the real estate marketplace. At least that’s the theory increasingly heard as lenders suffer through a tough year with slow home sales and few refinances.

“It might be time for the revival of the subprime lending industry,” according to The New York Times Magazine. “Long before these risky loans were blamed, in part, for helping usher in the financial crisis, subprime lending was embraced as a promising antidote to the excessive caution of mainstream lenders.”

Indeed, an important bit of evidence comes from the Urban Institute. In a report published earlier this year it explained that “credit availability for mortgage purchases has been very tight over the post-crisis period. In fact, over the past decade, the number of mortgages originated to purchase a home declined dramatically.”

How big a problem is this?

“We estimate the number of 'missing loans' that would have been made if credit availability were at normal levels — we find this number could be as high as 1.2 million units annually,” writes Laurie Goodman, a housing finance expert at the Urban Institute.

One solution to the problem of “missing loans” might be to ease lending standards so that more barely qualified borrowers can get financing but the widely reported Urban Institute study never uses the term “subprime.”

Bait & Switch

Subprime loans are not anyone’s idea of attractive financing. Basically, what we’re talking about are loans with high interest rates for individuals with poor credit, financing which before the mortgage meltdown was widely associated with big prepayment penalties and other harsh terms.

Whoops, correct that. It turns out that most subprime loans before the real estate collapse in 2006 and 2007 went largely to people who had GOOD credit, loans which should never have been originated.

“An analysis for The Wall Street Journal,” said the paper, “of more than $2.5 trillion in subprime loans made since 2000 shows that as the number of subprime loans mushroomed, an increasing proportion of them went to people with credit scores high enough to often qualify for conventional loans with far better terms.”

Specifically, the Journal reported that 55% of all 2005 subprime loans actually went to borrowers who qualified for FHA, VA and conventional financing. For 2006 the number rose to 61%.

“Many borrowers whose credit scores might have qualified them for more conventional loans say they were pushed into risky subprime loans,” the Journal reported. “They say lenders or brokers aggressively marketed the loans, offering easier and faster approvals — and playing down or hiding the onerous price paid over the long haul in higher interest rates or stricter repayment terms.”

Furthermore, we now know that the risky loans not requiring much, if any, down payment were one of the culprits in the foreclosure crisis. We dug into RealtyTrac data recently and found that of all distressed properties sold while in foreclosure between January 2007 and July 2014, 11% of them were originally purchased by the distressed homeowner using 100% financing — a good proxy for subprime. The percentage of loans gone bad that were originally purchased with 100% financing was as high as 20% for loans originated in 2007.

Credit Availability

The issue of credit availability is complex but a basic idea is this: There has to be some point at which borrower credit is so woeful and the risks to the lender are so great that the loan should not be made.

Most loans today fall within the “qualified mortgage” guidelines established by the federal government. In exchange for making qualified mortgages lenders are protected from virtually all borrower and investor lawsuits.

According to the National Association of Realtors, 97.4% of all loans originated in the second quarter were QMs, a figure which raises a question: Is it possible to have a subprime loan which is a qualified mortgage?

If we think of a subprime loan as financing with a high rate of interest than the answer is plainly yes. This has to be the case because there’s no interest limitation for QM financing, lenders can charge whatever they want if they meet all other standards. According to NAR, 12.8% of all loans originated in the second quarter were QMs with interest rates that were higher than the Average Prime Offer Rate (APOR) plus 1.5%. In other words, these were loans made within the QM rules and with higher — maybe much higher — rates of interest.

It’s important to say that a subprime qualified mortgage is not the same as the subprime mortgages of old. Yes, there can be a high interest rate but the loan must be fully documented. If there is a prepayment penalty it cannot exceed 2% the first year, 2% the second year and 1% the third year. Balloon notes are forbidden because all payments must be substantially equal. The debt-to-income ratio cannot generally exceed 43%. Under no conditions can loan officers be paid extra for selling a higher-priced loan. Points and fees cannot exceed 3% of the loan amount if the initial size of the loan is $100,000 or more.

If we need subprime loans to re-energize the housing market then we need to look no further than the FHA.

The FHA is well-known as a source of financing for first-time borrowers and individuals who want to buy with 3.5% down. According to Ellie Mae, FHA loans in August represented 20 percent of all originations.

Qualified borrowers can get FHA financing with 3.5% if they have a credit score equal to at least 588. Between 579 and 500 the rules are different: Borrowers can still get an FHA mortgage but they need at least 10 percent down.

This means that right now, today, lenders can offer FHA-insured subprime loans, loans where the lender has no risk because the FHA provides 100% coverage for any lender losses. Do lenders make such loans? Not hardly.

According to its 2013 report to Congress, HUD reported that the FHA originated 1,344,856 loans. Of this number, an average of 0.1575% over the four quarters in the year a credit score below 580. That’s approximately 2,118 subprime FHA loans in a nation with more than 318 million people.

The FHA’s subprime percentage used to be much higher. In 2008, more than 150,000 FHA loans went to borrowers with credit scores between 500 and 578, according to HUD. More amazing, thousands of loans were made to borrowers with credit scores between 300 and 499 — a practice discontinued in 2009.

The truth is that large numbers of subprime loans will not be returning any time soon and with good reason: As much as “easing” credit seems attractive — and as much as 1.2 million “missing” loans sounds like a calamity of some sort — no one wants a return to the days of no-doc loans, reduced qualification standards, massive losses and millions of foreclosures.

The reason we have fewer loans today is not so much that credit is “tight,” it’s because household incomes fell 8.7% between 1999 and 2013, according to the U.S. Census Bureau, while non-mortgage debt increased by $900 billion between 2004 and 2014, according the Federal Reserve Bank of New York. That’s not a winning formula if the goal is more home sales, it simply means that for many people the economy has contracted and with it any hope of getting a mortgage.

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