Saturday, March 29, 2008

Stripped Bare - Beneath the Feel Good Veneer of Subprime Lending

Chapter 3 - Vanilla Ice Cream, or Big Chicken Dinner?

When I first began working in the mortgage industry, in 1987, I strictly worked with “A” (prime) borrowers who were looking to purchase a home.  This was also true for the majority of “A” paper mortgage lenders in 1987.  The borrowers we worked with on the “A” side of the mortgage business were borrowers with good credit, decent jobs, and in most instances, the borrowers also had at least ten percent (10%) of the value of the home in cash as a down payment.  The vast majority of mortgages written for these “A” borrowers were thirty (30) year, fixed rate mortgages, which were called “vanilla ice cream” mortgages.

This does not mean that there were not borrowers out there in 1987 that had bad credit.  Nor does this mean that there were not mortgage lenders out in the marketplace that wrote “B,” “C,” and “D” paper (subprime) mortgage loans at this time.  “B,” “C,” “D” paper borrowers, and lenders, were out there in the marketplace in 1987, though the subprime lenders willing to risk lending to subprime borrowers in 1987 were operating on the margins of the mortgage industry, and the number of subprime lenders doing business in 1987 was minimal.  “A” (prime) paper mortgage lenders just did not, or would not, work with these subprime lenders.  We called these “B,” “C,” “D” mortgages (subprime loans), and borrowers, “big chicken dinners,” for reasons which will soon be related.

In 1987, the overwhelming perception of “B,” “C,” “D” (subprime) mortgage lenders, held by “A” paper lenders, was that subprime lenders were “sharks,” preying on the financially unfortunate. There was a distinct, slimy stigma associated with subprime lenders, and most “A” paper lenders wanted nothing to do with these subprime lenders, or the borrowers they tended to feed on.  And why would they?  The “A” paper side of the mortgage business was more than profitable, with gross margins per loan averaging around three and one-half percent (3.5%).

In 1987, subprime lenders were averaging gross margins any where between ten percent (10%) and twelve percent (12%) per loan, at the expense of borrowers’ equity, and they were gloating about this.  In fact, the few “B,” “C,” “D” mortgage lender representatives who were calling on “A” paper mortgage lenders in search of subprime business in 1987, proclaimed these gross profit numbers with pride, wondering aloud why any lender would work with “A” borrowers when so much money could be made off of borrowers who have no other recourse for mortgage financing due to their poor credit.  Why settle for vanilla ice cream, when you can have a big chicken dinner?

“A” paper lenders continued to perceive subprime lenders as “sharks” into the early 1990s.  But, this perception began to give way to a perception of envy of subprime lenders, as profit margins for “A” paper lenders gradually began to erode.  What was the impetus for the erosion of “A” paper lender profits?  The phenomenal growth of the mortgage broker business.

Though mortgage brokering had been around for many years on a small scale, it really began to take off in the late 1980s after the deregulation of the mortgage industry as a whole.  This rapid expansion of mortgage brokering brought so many players into the “A” paper mortgage loan origination market profits could do nothing but be squeezed.  “A” paper lenders saw their gross margins drop from three and one-half percent (3.5%) per loan, to three percent (3.0%), then to two and one-half percent (2.5%), then to two percent (2.0%), and even lower.  In 1992 there were even small one and two man mortgage broker shops who would work for a one percent (1.0%) gross margin per loan, operating as if they were in the grocery business.

Though this rapid growth of mortgage brokering was good for “A” borrowers, in the form of more competitive interest rates and lower fees, and fewer overrides for the lender, it also spurred the growth of subprime lending.  But this growth spurt in the subprime lending industry was not so much a benefit for subprime borrowers, as it was for the “A” paper lenders who were looking for ways to stem the loss of their profitability, which brought a new found legitimacy to subprime lending which previously it had lacked.

Unfortunately, it was a shady legitimacy.  As more and more “A” paper lenders, who previously had shunned subprime lending, began pursuing subprime borrowers, the excesses which had been whispered about the subprime lending industry, became mainstream.  No longer would subprime lending’s notorious profit making, at the expense of marginal borrowers’ home equity, be operated on the margins of the mortgage industry.  In fact, subprime lending would become the fastest growing segment of the mortgage industry.

Initially, many “A” paper lenders only would do three or four subprime mortgages per month.  Just enough subprime loans to pad the bottom line, but this would not last long.  As the easy profits which had been intimated to “A” paper lenders by subprime lenders began to roll in, many “A” paper lenders jumped feet first into the “easy” money mode of subprime lending and simply let their “A” paper business languish.

Other “A” paper lenders setup subprime lending DBA’s (doing business as) entities, not wishing to tarnish their “A” paper lender reputations with subprime lending’s previously noted stigma.  But, as larger and larger nationwide mortgage lending corporations jumped into this very profitable segment of the mortgage business, the stigma previously associated with subprime lending soon received wholesale legitimization.

Though the “A” paper side of the mortgage industry continued to grow; just look at the stock performance of the Federal National Mortgage Association (Fannie Mae) over the years; in comparison, the growth of the subprime loan industry rocketed into the stratosphere.  Subprime lenders became more and more visible, and rapacious, across the nation.  This is turn led to “A” paper lenders; who previously would not have considered advertising the fact that they participated in lending to subprime borrowers; to begin saturating the market with myriads of advertisements targetted specifically to subprime borrowers spouting “easy” mortgage money availability, no matter what borrowers personal credit circumstances may be.

Though the phenomenal growth of the mortgage broker business was initially the main catalyst for the rapid growth of the subprime lending industry, the national mortgage lenders soon became the major players, and legitimizers, of the subprime lending industry nationwide.  These national mortgage lenders brought a whole new meaning to the term “easy” money.

Posted by John Venlet on 03/29 at 05:29 AM
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