Considering Subprime?

Mortgage Banking, Oct, 2000 by MARY McGARITY

Pricing is key

Knowing how to price a subprime loan is essential to succeeding in the business. "The key to subprime lending is to understand that a B-minus or C loan is not expected to perform like a Fannie or Freddie loan, and you have to price it for the risk," says Lumsden.

"Lenders can't be giving away the loans," agrees Fitch's Abruzzo. "These loans are more prone to delinquencies, possibly defaults or bankruptcies, and you have to be compensated for that risk," he says.

And the servicing of higher-risk mortgages is more difficult than that of prime loans because those customers generally require a higher level of communication. Many prime lenders with subprime units--including Countrywide--have a separate division for servicing the nonprime loans. "A lot of these folks are inconsistent in their bill-paying, so there's more communication with them. You just have to assume they're going to have a hard time making their payments on time, and they're not going to be organized," Lumsden says.

Nonprime customers often require help in becoming better disciplined and more organized in understanding their cash flow, according to Lumsden. Consequently, the cost of servicing is higher than in the conforming market, but the pricing on the loans should take that higher servicing cost into account, he says.

The entrance of Fannie and Freddie

The entrance of the secondary market agencies into the top-credit-quality tier of subprime lending is drawing little enthusiasm from many in the subprime industry, although some applaud the move. "It's an infringement of their charter," the head of one subprime company says. "I think of the GSEs as mainly providers of homeownership, and subprime lending is mainly debt consolidation. I don't see how that puts people in homes," he says.

Fannie Mae and Freddie Mac are "getting into the market to skinny-up margins and just skim off the top business, which is going to leave the subprime lenders with whatever's left," another subprime executive says.

The entrance of Fannie Mae and Freddie Mac into nonprime lending is "potentially a competitive threat, to the extent that it puts pressure on the yields in the business," Fitch's Abruzzo says. "It could be a threat to issuers who don't have the balance sheets that Fannie Mae and Freddie Mac do." But for traditional mortgage bankers that don't care to be issuers of subprime securities, the movement of Fannie and Freddie into areas of subprime lending is more welcome. It allows those prime lenders to branch further into niche products.

There's an issue about how the loans will be serviced, a few lenders say. "There are probably only six or seven companies in the United States that I would point to as good, specialized, default servicers," says Chase Manhattan's Cooper. "If people are going to originate subprime loans and send them to Fannie and Freddie as part of their program, who is going to service those loans? I think there is an issue on the collection and subservicing side as to how these loans will be serviced."