Wednesday, April 09, 2008

Stripped Bare - Beneath the Feel Good Veneer of Subprime Lending

Chapter 11 - Cash in Your Hand, and a Hook

Subprime lenders’ advertising typically trumpeted the following message to borrowers – Bad credit, no credit, no problem, we can refinance your home, lower your monthly payments, and put cash in your pocket to boot.  The fact of the matter was, subprime lenders usually could do exactly what they were advertising they could do.  Pay off some of your debt, and put cash in your pocket too.

Borrowers who had a low credit scores (see Chapter 10), or low credit grades (see Chapter 9), or both, and at least ten percent (10%) equity in their current home, in all likelihood could qualify for a subprime loan.  The dilemma for borrowers considering such a deal was would there be more than just a short term benefit to them?  Or, would the benefit of refinancing with a subprime loan simply evaporate before the new mortgage was recorded at the local county clerk’s office?

There were real and quantitative benefits to utilizing a subprime loan to refinance your home, if you were in troubled financial straits and had sufficient equity in your home which a subprime loan would allow you tap.

It was not unusual for a subprime lender to reduce borrowers’ monthly outgoing payments by two to three hundred dollars ($200.00 - $300.00) per month, and an extra $200.00 to $300.00 dollars in your hand each month could and can go a long way.  Additionally, in many subprime loan refinance transactions, the borrower would walk away with money in their pocket.  What’s not to like about that?

One of the issues not to like about the above scenario is what was not being said to subprime borrowers.  What, in the vast majority of cases, was not being said to subprime borrowers was that they were going to remain subprime borrowers unless they got off the misuse of credit gravy train and began living within their means, and subprime lenders only gave the merest of lip service to this fact, because this fact did not sell subprime mortgages.  But what was not being said, and what was being ignored by subprime lenders, did set the hook for the possibility of future refinances.

As I intimated previously, subprime lenders were adept at selling the sizzle aspect of subprime loans.  The sizzle of course being the cash in your hand so often and so broadly advertised by subprime lenders.  The sizzle also emanated from the consolidation of subprime borrowers’ debt messages in subprime lending advertising, which would result in increased monthly cash flow for subprime borrowers, and this was also a money driven draw for less than creditworthy borrowers.  But the real hook which allowed subprime borrowers to be reeled in again and again to be refinanced, until many had no remaining equity in their homes, were the overly generous underwriting guidelines set by the subprime lenders themselves.

Perhaps the most overly generous subprime underwriting guideline was what is known as the debt to income ratio.  The debt to income ratio is simply the percentage of your monthly gross income that you are spending on your house payment and other monthly long term debts.  For conforming prime loans, meaning “A” paper loans which are underwritten to FannieMae (FNMA) and FreddieMac (FHLMC) guidelines, borrowers are typically limited to spending thirty-eight percent (38%) of their monthly gross income on their house payment plus their long term debts (long term debts are any credit cards or lines of credit with outstanding balances, and any installment loans with over ten (10) months of payments still outstanding).  Bear in mind that his 38% debt to income ratio was set by FNMA/FHLMC for solid, good credit borrowers.

In the subprime lending industry, weak, poor credit borrowers were allowed to spend up to fifty-five percent (55%) of their monthly gross income on their house payment plus monthly long term debts.  Subprime lenders were allowing the highest risk borrowers to carry debt loads which even the most creditworthy prime borrowers were not allowed, and which are not, realistically, financially advisable for any individual.

Some subprime borrowers, who were fortunate enough to have enough equity in their homes to pay off all their credit card debt and any installment debts they may have had, actually ended up with house payments alone which ate up 55% of their monthly gross income.  In circumstances such as this, any new credit card debt or installment loans taken on by borrowers could quickly push them over the edge.  And many subprime borrowers, after refinancing to pay off existing debts, went right out and took on new debts.  Unfortunately, when they reached out to a subprime lender once again for a bailout, in most instances they were out of luck.  Their debt to income ratios were further out of line than the initial out of line 55% subprime guideline for debt to income.

Another overly generous, and foolish subprime underwriting guideline, which I have previously mentioned, was not requiring subprime borrowers who currently had outstanding collections, credit card charge offs or auto repossessions with outstanding balances to pay off these debts.  In effect, subprime lenders were rewarding subprime borrowers for being credit abusers.  Is it any wonder, then, that the subprime lending industry ended in such disaster, and that so many subprime borrowers have ended, and are ending, up in foreclosure?

Why didn’t subprime lenders inform borrowers of the continued negative effect unpaid delinquent accounts have on borrowers’ credit ratings, and then recommend to the borrowers to correct them?  Why did subprime lenders’ account executives only inform borrowers that, if they made their mortgage payments on time for twelve (12) consecutive months, everything would be good, and that they would be transformed into prime borrowers.  Why did subprime lenders allow subprime borrowers to spend 55% of their monthly gross income on their house payments plus long term debts rather than utilizing a more realistic debt to income ratio?

The answer to these questions is subprime lenders told borrowers only what they wanted to hear to overcome borrowers’ objections to the terms of the subprime loans they were offered, approved for, and closed on.  And what did most borrowers want to hear after they applied for a subprime mortgage refinance transaction?  They wanted to hear that even though they had poor credit and did not pay their bills on time, they were approved for the loan they had applied for, that they were going to receive a bit of cash in their hand, and that their total monthly payments were going down as compared to their current total monthly payments.  The borrowers’ other delinquent credit issues, which should have been addressed and corrected to actually assist subprime borrowers in becoming a prime borrowers, were simply left unmentioned, unresolved, and delinquent, thus maintaining their negative influence on the borrowers’ credit ratings.  After the loan was closed, and the subprime lender had pocketed their profit from the equity in borrowers’ homes, the borrowers were left on their own, under the impression, with strong encouragement from the subprime lender, that all they had to worry about after the closing was making their mortgage payments on time for the next twelve months (12) and they would be transformed into prime borrowers.  Which of course infrequently happened.

But more tellingly, subprime lenders did not address borrowers’ credit collection accounts, or other underlying delinquent credit issues which hold down borrowers’ credit scores, requiring these accounts to be satisfied, because the profit margins on prime borrowers are three to four percent lower than the profit margins on subprime borrowers.  Additionally, and just as important as the profit margins mentioned above, if subprime lenders required all subprime borrowers’ delinquent accounts and collections to be paid off, which actually would have benefited subprime borrowers, subprime lenders would have forfeited their most powerful motivating sales tool.  The cash in your pocket incentive which hooked so many of the subprime borrowers in such dire financial straits today.

Posted by John Venlet on 04/09 at 05:30 AM
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