Considering Subprime?

Mortgage Banking, Oct, 2000 by MARY McGARITY

You have to wonder if it's worth the risk of getting into subprime lending today. Yet many prime lenders are doing it. Still, the business challenges of "nonprime" lending are considerable. They include a state legislative crackdown likely to leave a patchwork of new predatory lending laws, higher delinquencies, costly servicing and shrinking profit margins.

THERE'S A LOT OF PRESSURE LATELY ON SUBPRIME LENDERS. Narrowing margins, credit-quality issues, potential competition from Fannie Mae and Freddie Mac and, especially, the heightened scrutiny of predatory lending practices have all made the subprime mortgage industry--already a high-maintenance business--even more challenging.

So why are some mortgage companies and banks getting into the business or expanding already-existing subprime lending units? Because the earnings potential, although not as great as it once was, is still very good. And mortgage originators need to expand their product lines to reach more customers.

Companies are getting into nonprime lending in varying degrees. Some mortgage companies and banks, such as Calabasas, California-based Countrywide Home Loans and New York-based Chase Manhattan Mortgage Corporation, have created their own subprime units internally and originate a range of nonprime and subprime loans. San Francisco-based Wells Fargo & Co. acquired Des Moines-based Norwest Mortgage, Inc.'s, Directors Acceptance subprime division when the two companies merged in 1998.

Other companies are taking smaller steps into the market and have begun originating mortgages with credit characteristics just outside the parameters dictated by Fannie Mae and Freddie Mac. Ann Arbor, Michigan-based InterFirst Wholesale Mortgage Lending started buying A-minus loans earlier this year. Miamisburg, Ohio-based National City Bank, through the purchase of two companies, is now offering what it terms nonprime or nonconforming products, but stops short of subprime. Others, such as Columbia, South Carolina-based Fleet Mortgage Group, Inc., are making a strategic decision not to enter the subprime market at all, other than a very small percentage of loans originated through a wholesale division, which are then immediately sold.

For the traditional independent subprime lender, especially, the business has become a lot tougher. "Monolines don't have a lot of capital, so they're going to need a capital infusion," says Sam Cooper, executive vice president of Chase Manhattan Mortgage Corporation. "There's a lot of pressure on separate subprime businesses as entities because, number one, Fannie Mae and Freddie Mac are getting into the business from the top end, so they're going to be looking to skim off the best-quality product [in the nonprime sector]. Then there's pressure on the bottom end from the predatory lending focus," Cooper says. "B&C has always been a high-touch, high-service business. Since the market blew up in 1998, the value of the loans has come down--so you're getting squeezed on the revenue side. It's hard to adjust your cost downward. So you have credit narrowing, the GSEs [government-sponsored enterprises] getting into it, expense constraints and predatory lending issues. Other than that, it's a really attractive busi ness."

As more subprime companies go out of business and big banks step in, the smaller, traditional subprime players are feeling the squeeze more than anyone. "When subprime loans first came into fashion, the big guys wanted nothing to do with it," says one senior executive at an independent subprime company. "Now the biggest players in the subprime market are all the big banks. They've sat up and taken notice of the profitability, and they've attacked it in a real big way. If you look at all the top players in subprime lending, they're all affiliated with or owned by monster banks that at one time frowned at this type of lending."

Why the change of heart? "The big banks realized there's profitability in it, but also I think they realized they could do it better than the original subprime lenders could," the senior executive says. "They could do it with a lower cost base and more efficiently. Their cost of funds, their technology and their efficiencies make it tough for us to compete with them."

Whether subprime lending is a good business for banks and mortgage companies to get into is a matter of debate. "I would think subprime would be an area banks would be less likely to go into because of the high risk of predatory lending charges," says Linda Stesney, managing director in residential mortgages at New York-based Moody's Investors Service.

"Subprime is a high-loss business. There are very high delinquencies. Depending on the quality of the appraisals, you can end up with very serious loss seventies," Stesney says. "With all the predatory lending frenzy, I can't see it as a very attractive business for banks to be getting into now. They're highly regulated entities, and it can be a bad mark on their reputation. A lot of the finance companies were short-term players and weren't that worried about their reputations. Banks have a much longer-term view."