Are we seeing the return of subprime?

A new crop of non-prime loans avoid the risk layering seen in the foreclosure crisis

Hollywood loves sequels, and for good reason. Once a studio has established that audiences love a character, a story, or a franchise, it’s a fairly safe bet they’ll come back to the theaters again and again (and again).

The numbers bear this out. None of the eight Harry Potter movies grossed less than $320 million. The two movie sequels to Marvel’s first Captain America out-earned the original, which grossed $192.5 million, compared to the sequels, which took in $269.8 and $404.4 million, respectively.

Some sequels are box office disasters and often deservedly so. Who can forget Jaws 4,The Revenge? Or “classics” like Cannonball Run 2, Caddyshack II, or the Saturday Night Fever follow-up, Staying Alive?

Even Hollywood knows better than to produce a sequel when the original movie is truly, horrifically bad. That’s why, thankfully, we haven’t seen sequels to such all-time cinematic disasters as Howard the Duck, Gigli, The Last Airbender, Jack and Jill, Glitter, or Battlefield Earth. Which brings us, in an admittedly roundabout way, to the question of whether we’re about to see a sequel of sorts in the mortgage industry: The Return of the Subprime Loan.

I’m sure you remember the original in this series: The Great Recession. It was covered by news organizations everywhere. Lots of drama. Easy-to-hate bad guys. International intrigue with established corporations disappearing virtually overnight, and governments scrambling to prevent financial ruin. It had a complicated plot that took more than a decade to figure out, with an ending that no one wants to see again – more than 5 million homes lost to foreclosure.

All of this was precipitated by reckless lending practices generally ascribed to subprime loans: loans considered so toxic that the government responded with the Dodd-Frank Act — a 2,300-page monstrosity with more than 400 new rules and mandates and the creation of a new uber-regulator, the Consumer Financial Protection Bureau, to ensure the behavior that led to the crisis would never be repeated.

And yet, 10 years after Lehman Brothers’ failure signaled the beginning of the mortgage market meltdown, lenders are beginning to market loan products called non-prime, near-prime, non-QM and non-agency.

Many of these loan products seem eerily familiar, and beg the question: Are they really just subprime loans in disguise?

WHAT IS A SUBPRIME LOAN?

Before delving too deeply into whether or not today’s loan products are actually just subprime loans with a fresh coat of paint, it might be helpful to define what exactly a subprime loan is.

The website Investopedia offers a good definition of the term subprime:

“Subprime is a classification of borrowers with a tarnished or limited credit history. Lenders will use a credit scoring system to determine which loans a borrower may qualify for. Subprime loans carry more credit risk, and as such, will carry higher interest rates as well. The term subprime gets its name from the prime rate, which is the rate at which people and businesses with excellent credit history are allowed to borrow money.

“Occasionally some borrowers might be classified as subprime despite having a good credit history. The reason for this is because the borrowers have elected to not provide verification of income or assets in the loan application process.

The loans in this classification are called stated income and stated asset loans.”

Although this definition helps explain the general concept, it’s a bit light on details. While subprime loans are generally acknowledged as being inherently riskier than conventional loans, there are no hard and fast rules about how to separate one from the other. 

However, there are a number of criteria that have historically resulted in a loan being classified as subprime: low FICO scores; high loan-to-value ratios; high debt-to-income ratios; insufficient cash reserves; and incomplete or non-traditional documentation.

There have been general industry guidelines over the years – recently codified by the CFPB’s Qualified Mortgage and Ability-to-Repay rules – helping underwriters determine what type of loan a borrower might qualify for. For instance, a FICO score of 720 or above would be likely to qualify a borrower for a conventional loan, while FICO scores below that would almost certainly be considered subprime.

A borrower applying for a conventional loan was encouraged to have an LTV no higher than 80% and a back-end DTI in the mid-30% range, along with three-to-six months of cash reserves, and at least three years of income tax returns and bank statements to provide proof of financial capability. And, of course, to be a conventional loan, the amount of money being financed had to fall within the loan limits established by Fannie Mae and Freddie Mac.

Any loan that fell outside those guidelines was likely to be classified as a subprime loan. And the degree to which an individual loan deviated from the guidelines affected how risky it was considered to be. For example, a borrower with a 600 FICO score would be considered a higher risk than a borrower with a 680 FICO. An LTV of 90% was deemed riskier than a ratio of 85%. The degree of risk involved determined the likelihood of a loan application being approved, and the cost of the loan to the consumer, both in terms of points paid and the interest rate charged.

For many years, these loans performed very well, much like their government-insured FHA counterparts. Gradually – and then not so gradually – subprime loans crowded the more-expensive – and harder-to-qualify-for – FHA loans out of the market as the decade of the 2000s began. And the horror movie that led to the mortgage market meltdown began.

PRODUCING A DISASTER MOVIE

Much has been written about everything that went wrong during what we’ll call “the subprime era,” but in order to compare those loans to the loans being produced today it’s important to provide at least a brief recap.

Fundamentally, one of the biggest problems was what has been referred to as “risk layering.” Simply speaking, subprime lenders ignored decades of proven underwriting fundamentals to issue as many loans as possible.

A borrower with a FICO score of 550 isn’t necessarily a bad credit risk. That same borrower with a DTI ratio of 50% becomes more of a credit risk. If that borrower also has no money in the bank, the risk increases even more. And offering this borrower a loan with a 100% LTV dramatically increases the risk.

Add “stated income” rather than proper documentation, and a home that was grossly overvalued in the first place, and you’ve created a loan with virtually no chance of performing. But just to make sure, why not qualify the borrower with a ridiculously low “teaser” rate that will reset in a year or two, and result in the monthly loan payment doubling?

These loans – cleverly dubbed “NINJA loans,” because the borrower had “no income, no job, and no assets,” were the sort of toxic products that became emblematic of the subprime era. Unsurprisingly, loans issued to unqualified borrowers on overpriced homes failed at spectacular rates, approaching a 16% foreclosure rate at the peak of the crisis – roughly three times the historical foreclosure rate on higher-risk loans.

It was the behavior of the subprime lenders during this period – not the loan products themselves – that caused the problem. (Borrowers and Wall Street investors also had a role in this disaster flick, but that’s a story for another day.)

SEQUEL, OR AN ENTIRELY DIFFERENT MOVIE?

The phrase “subprime loan” still strikes fear into the hearts of consumers, regulators, politicians, the media, and even many lenders.

This is unfortunate, because for many years an overwhelming majority of subprime borrowers were able to achieve sustainable homeownership or tap into their home’s equity to better their financial circumstances.

But it’s also completely understandable, considering the carnage that the bad loans of the early 2000s precipitated.

Unfortunately, the mortgage industry, in an effort to remove as much risk as possible from lending, probably overcorrected.

A report from the Urban Institute concludes that some 6.3 million borrowers who would normally have qualified for a loan were unable to get one due to the risk-averse lending environment between 2009-2016.

Most of the larger banks stopped issuing loans that didn’t fit precisely within the QM and ATR guidelines put in place by the CFPB (with the notable exception of jumbo loans written for high net worth individuals that the banks kept in their portfolios).

But finally, in 2018, a number of nonbank lenders (including my employer, Carrington), began to offer loan products to borrowers with less-than-perfect credit profiles.

A low FICO score no longer meant an automatic disqualification and neither did a relatively high DTI ratio.

Critics were quick to make claims that these new non-prime, non-QM or near-prime loans were merely the toxic subprime loans of years past with a dab of lipstick or a fresh coat of paint.

But they’re not.

Could there be a return to the recklessness that characterized the subprime era? It’s possible – there are already lenders offering non-prime loans to borrowers with one month’s bank statements.

But the combination of more regulatory oversight, less interest among investors to purchase low quality loans, less consumer interest in entering into a high-risk financial engagement and fresh memories of the absolute nightmare caused by all the bad practices that led to the mortgage market meltdown seem to make Great Recession 2 – Nightmare on Main Street a movie very unlikely to ever be produced.

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