Subprime mortgage lending earned a bad reputation in the years leading up to the financial crisis of 2007-2008, and rightfully so. In the midst of a freewheeling lending environment that ignored most tried and true underwriting standards, Subprime loans played a significant role in a cascade of default causing harm to borrowers, lenders, and investors alike.
When done correctly, however, such loans offer a safe alternative for credit-worthy borrowers who might be shut out of mortgages underwritten for sale to the conventional market. For many years before the mortgage meltdown, such loans were a vital pathway for homeownership and one company is again proving they can be a positive force for the industry as well as borrowers.
About four years ago, Citadel Servicing Corp. (CSC), based in Irvine, California, became the first company since 2008 to expand the credit box by offering standard and alternative income documentation products to borrowers, funding loans as high as $3 million and offering a second-lien program. But the company takes an entirely different approach than the practices often associated with subprime lending, creating programs that effectively manage the risk involved.
In fact, CSC does not use the term subprime. According to Will Fisher, SVP of sales and marketing, at CSC “Subprime is offensive.” CSC has coined a more apt descriptive word for of this part of the mortgage world, “non-prime.”
“People have been hesitant to make this kind of loan since 2008 and even wondered how we could even fund them,” said Fisher. “Even now people ask how we are making these loans. The truth is, subprime is not a four-letter word. And non-prime is an even better description of what is occurring since 2011-12 in this loan type.”
CSC created a loan program four years ago that allows self-employed borrowers to document their income using bank statements instead of tax returns like 1040s or 1099s. The company requires two years of bank statements to validate cash flow and thus extrapolate income. This gives the company critical insight into a borrower’s ability-to-repay (ATR).
“We believe that 24 months of continuous bank statements are a very reliable look into what a person actually lives on per month when compared to tax returns or even a W-2s,” Fisher said. “Because these borrowers are self-employed, they want the benefits that come with the legal ability to write off expenses. That can make the use of tax returns as conventionally underwritten a poor barometer of ability to repay, but we’re able to document income in a different way. And we stay in the spirit of ATR and QM loans by requiring a two-year history.”
CSC offers up to 90% LTV for self-employed borrowers with a 700 credit score and up to 80% LTV for a credit score of 600 or higher (the typical threshold for subprime is 620). This program has huge potential for growth since many of the 14.6 million people who are self-employed may not qualify for a traditional QM loan, even with a high credit score and adequate income.
What about risk?
CSC not only addresses risk on the front-end through a rigorous underwriting process, but also services its own loans. This long term involvement in the loan process gives the company every incentive to fund high-quality loans. By being the servicer, CSC is also provided a critical window into how their loans are performing, which helps them adjust origination program guidelines accordingly.
Unlike other companies that might just provide guidelines to correspondent sellers and then lets them take the risk, CSC gives sellers a platform for flow or bulk and is willing and able to hold their hand through the process, showing them how to competently originate this kind of loan.
“Then we buy the loan and service it, so the buck stops with us providing very little risk for our sellers who originate this product,” Fisher said. “One of the biggest problems in the financial crisis is that no one was listening to the servicers about how loans were performing. If you know that and manage accordingly you can effectively manage these loans.”
The success of CSC’s approach can be seen in the performance of the loans. Its non-QM programs, for example, “have a 3%+/- delinquency rate since 2011 and astonishingly no losses,” Fisher said.
“This is a distinct improvement in the performance seen in subprime loans before the crisis. The vast majority of loans in that pre-2008 era had no income information. Stated income loans coupled with high loan-to-values led to double-digit default rates in the 1990s and 2000s. Bank statement programs were not a factor in that era, but if they had been the loans would have performed significantly better,” Fisher said.
“Our approach to non-prime makes us unique. We have a good feel for what a borrower can reasonably afford and we can adjust to ensure that we are managing risk appropriately.”