Sub-Prime Lending: After the fall, what's next?

Real Estate Weekly, Dec 15, 1999

What does an industry do after its. "100 Year Flood"? What will the year 2000 bring to the sub-prime lending industry after its collapse? These are two of. the questions non-conforming lenders will face in the coming year, and the objects of the annual business projections made by Fairbank Mortgage Company.

"What happened to this industry last year is the equivalent of a 100 Year Flood," said Craig Cooper, executive vice president of Fairbank and Colony Mortgage. "What we have this year is a whole new ballgame. The changes stem from the fourth quarter of 1998, when a 'sea change' took place in the non-conforming business. What precipitated this change was the collapse of secondary market pricing. This led to a total breakdown of the sub-prime industry as we knew it. All the leading independent companies are either bankrupt, out of business, or have been forced to consolidate into larger banking entities. As a result, we now operate in a totally different landscape."

He pointed out that the 1990's saw the growth of an industry fueled by the liquidity made available by Wall Street. As that liquidity door slammed shut, it led to a totally different landscape. "There were a lot of abuses," said Cooper. "Like any industry that grows quickly due to an influx of capital, it had to face a radical change when the money stopped coming. The year 1999 was that radical change, and today it's a totally different business."

Cooper points to an industry that is now dominated by major financial institutions. "We expect that they will be the dominant players as we move forward," he said. "The days of the mid-sized mortgage companies with access to virtually unlimited capital are over."

What trends will dominate this now-changed business? Cooper points to these factors that he feels will shape sub-prime lending in the year 2000:

A Make-or-Break Year for On-Line Business: In 1999, the mortgage business saw the emergence of an on-line industry segment. Cooper expects the year 2000 to be the one in which they prove their worth. "We've seen new mortgage companies evolve with only on-line presence," he said. "Unlike other portions of this business, these companies have had access to abundant capital because of their on-line nature. My opinion is that they will have to become profitable in the near future to prove that their business models are viable. Because of their 'dot.com' designation, investors have overlooked their need to be profitable up to this point. But we project that this will be the year in which they have to answer the question: 'Are these business models viable in the long-term?'"

Cooper predicts that the online-only model will not work in the long-term. He pointed out that the industry is projecting that 25 percent of business will be dome online by the year 2003. "That will leave 75 percent to be done face-to -face," he said. "We expect that the model that will work will combine 'bricks and clicks.' You will always have the need for human interaction in this business. Selling mortgages isn't selling books and backpaks."

Technology as the Critical Success Factor: The major issue in the coming year will be these of technology to its utmost, projects Cooper. "For all mortgage companies to survive in the coning year, they must be driven by technology," he said. "The reduced margins that are the new reality of this marketplace will force us to control costs and become as efficient as we can. Automated underwriting and automated processing will dramatically increase the efficiently of what can be done. It will have to. Today, more than 50 percent of staffing in this industry is devoted to loans that don't close. We will need to go to automation to head off these unproductive loans at the pass."

Government Sponsored Enterprises to Make Presence Felt: In the coming years, Cooper expects to see a greater presence in the sub-prime mortgage industry by Fannie Mae and Freddie Mac. "Not only will they be looking to make loans with A-minus credit ratings, we forecast that you will see them moving into the automated underwriting of B and C loans," he said. "This will provide a continued threat to the sub-prime industry as we know it today. Survivors are going to have to learn to operate on this new playing field."

Tightening of Underwriting Guidelines: Cooper expects the coming year to bring a tightening of underwriting guidelines and an increased emphasis on quality control, particularly in the area of appraisal reviews. "There have been abuses and this can't continue," he said. "Many of the problems in this industry have been brought on by lax underwriting guidelines. This is an issue that will affect everyone, from the smallest broker to the biggest correspondent buyers of loans."

Increased Emphasis on controlling Fraud: Look for an increased emphasis on controlling fraud. Cooper foresees a push toward higher file quality and integrity. "We expect to see an increased use of credit scoring and more due diligence imposed by the secondary market," he said.