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May 6, 2008

Wikipedia: Subprime lending

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Subprime lending (also known as B-paper, near-prime, or second chance lending) is lending at a higher rate than the prime rate. In the US, the term “subprime” in mortgage lending, refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. While often defined or defended as lending to borrowers with compromised credit histories, the Wall Street Journal reported in 2006, 61% of all borrowers receiving subprime loans had credit scores high enough to qualify for prime conventional loans.[1] It may or may not reflect credit status of the borrower as being less than ideal and may not even reflect the interest rate on the loan itself. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons.

Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, allegedly poor credit histories (which can be extraordinarily inaccurate) and potentially adverse financial situations that are sometimes associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the perceived increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards. The most abusive subprime lending practices are, arguably, short-term “payday” loans.

Subprime lending is highly controversial. Opponents alleged subprime lenders engaged in predatory lending practices such as deliberately targeting borrowers who could not understand what they were signing, or lending to people who could never meet the terms of their loans. Many of these loans included exorbitant fees and hidden terms and conditions, and they frequently lead to default, seizure of collateral, and foreclosure.

There have been charges of mortgage discrimination on the basis of race.[2] Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.[3]

As the result of an ongoing lending and credit crisis in the subprime industry, and in the greater financial markets which began in the United States, the controversy surrounding subprime lending has expanded. This phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets. Millions of borrowers are making inflated payments and cutting back on other parts of their budget. Hundreds of thousands of borrowers have been forced to default or file for bankruptcy. Hundreds of subprime lenders or brokers have closed, some have filed for bankruptcy and several have been acquired.

Contents

Background

Subprime lending evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it coupled with the relaxation of usury laws and an unwillingness on the part of legislators at the national level to recognize the inherent risks to consumers. Traditional lenders are more cautious and have turned away a record number of potential customers.[citation needed] Statistically, approximately 25% of the population of the United States falls into this category.[citation needed]

In the third quarter of 2007, subprime ARMs only represented 6.8% of the mortgages outstanding in the US, yet they represented 43.0% of the foreclosures started. Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.[4]

The American Dialect Society designated the word “subprime” as the 2007 Word of the year on January 04, 2008. [5]

Definition

Fannie Mae has lending guidelines for what it considers to be “prime” borrowers on conforming mortgage loans – those loans they will buy or securitize into the credit market. Their standard provides a good comparison between those who are eligible for prime vs. subprime loans. Eligible borrowers for prime loans have a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income ratio (DTI) no greater than 75% (meaning that no more than 55% of net income pays for housing and other debt), and a combined loan to value ratio of 90%, meaning that the borrower is paying a 10% downpayment.

Subprime lenders

To access this increasing market, lenders often take on risks associated with lending to people with allegedly poor credit ratings. Subprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many subprime loans, this risk is offset with a higher interest rate or various credit enhancements such as Private Mortgage Insurance (PMI). In the case of subprime credit cards, a subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card. These late fees are then charged to the account, which may drive the customer over their credit limit, resulting in over limit fees. Thus the fees compound, resulting in higher returns for the lenders.

Borrower profiles

Subprime can offer an opportunity for borrowers with an allegedly less than ideal credit record to gain access to credit. Borrowers may use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down on a high interest credit card. However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates, increased fees and other increased costs. Some of these costs are often hidden to the borrower. On a more positive note, subprime lending (and mortgages in particular), allegedly provide a method of “credit repair”; if borrowers maintain a good payment record, they should be able to refinance back onto mainstream rates after a period of time. In the UK, most subprime mortgages have a two or three-year tie-in, and borrowers may face additional charges for replacing their mortgages before the tie-in has expired.

Generally, the credit profile keeping a borrower out of a prime loan may include one or more of the following:

  • Two or more loan payments paid past 30 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months;
  • Judgment, foreclosure, repossession, or non-payment of a loan in the past;
  • Bankruptcy in the last 7 years;
  • Relatively high default probability as evidenced by, for example, a credit score (FICO) of less than 620 (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood.
  • Accuracy of the credit line data obtained by the underwriter.

Private Label Credit

This group of credit companies includes major banks such as Wells Fargo, CitiBank, GE Credit, Household finance, and more. While it is not certain what percentage of sub-prime lending involves the private label branding of the retail chains (i.e the GAP, Victoria’s Secret, Old Navy, etc and most furniture and appliance retailers), most national retail chains use some form of sub-prime lending as a major percentage of their marketing strategy. A combination of aggressive deferred interest programming and predatory interest rate and penalty fee policies result in high default rates that must be offset by those aggressive lending practices. It is common for a $200,000,000 furniture retailer to have 50% of their long-term business be derived from the direct result of private label credit promotions.

This type of sub-prime lending at the retail level is particularly difficult for consumers to manage due to the long delay typically involved before the 3, 4, or 5 years deferral period expires. During this ‘period of free interest’, accrued interest builds at very high rates which can exceed 25%, and more.

Types

Subprime Origination, Securitization and Servicing

Some subprime originators (mortgage companies or brokers) sell high-risk residential or commercial loans with a variety of gimmicks that can trap low income borrowers into loans with increasing yield terms that eventually exceed borrower’s capability to make the payments. Most of these loans are originated for the sole purpose of selling them into securitization conduits, which are special purpose entities (REMICs) that issue Residential Mortgage Backed Securities (RMBS), bonds, securities and other investment vehicles for resale to pension funds and other fixed income investors. The same process takes place for some commercial mortgages (CMBS). Commercial mortgages carry the “Depositor” warranty by a Mortgage Loan Purchase Agreement (MLPA) registered with the SEC as part of securitization registration.

Some of these Mortgage Originators are owned or controlled by major financial institutions which provide a “Warehouse” line for their lending. For example, First Franklin was owned by Merrill Lynch and WMC was owned by GE. These financial institutions then remain in control of these loans as “Trustee”, “Servicers” and “Controlling Class” of the REMIC trusts in hopes of deriving significant fees and other income from management of Taxes, Insurance and Repair Reserve Funds required by the terms of these mortgages.

In most cases, should these loans default, the Servicing is passed to “Special Servicers” who stand to reap significant “Workout”, “Foreclosures” and Real estate owned (REO) management fees. The Special Servicers are directed by “Directing Class” or “Controlling Class” which comprise of majority holders of the lowest class of REMIC Trust securities also referred to as “First Loss” or “B-Piece” holders.

Upon liquidation of foreclosed assets or” mortgage collateral” usually at a Sheriff auction, the Special Servicer purchases the collateral for a dollar over the highest bidder, at a fraction of the original Mortgage loan. The difference between the foreclosure sale and the note amount is referred to as shortfall and becomes a liability of the Borrower and Guarantors. This shortfall continues to accumulate interest at default rates which form additional “Servicing Income.” The various fees and income generated from servicing these loans form the basis of FASB MSR which is booked as an asset by these financial institutions thus driving up the corporate equities, shareholders values and management bonuses.

The shortfall of loan repayment is usually repaid as a result of ”Repurchase Demand” by Special Servicer on GSE or loan seller to REMIC Trust also called “Loan Depositor.” The purchased collateral at auctions by Special Servicers are referred to as REO properties which then can be marketed and sold for market value. Special Servicers usually keep the “Upside” or difference between auction price and market sale of the collateral. These foreclosure fees and REO income form a major incentive for Servicers to purchase the “Servicing Rights” of the REMIC trusts from Trustees who, depending on the terms of the Pooling and Servicing Agreement (PSA), have the authority to replace Servicers. It is not uncommon for a predatory Servicer to pay millions of dollars to procure the “Servicing Rights” of the REMIC trusts in hopes of successful foreclosures and equity stripping from Borrowers, Guarantors, Loan Sellers and Investors.

REMIC Trusts are “Passive” or “Pass-Through” Entities under the IRS code and are not taxed at trust level. However, the bond-holders are expected to be taxpaying entities and are taxed on interest income distributed by the REMIC trusts. REMIC trusts are forbidden from any other business activities and are taxed 100% on any other income they may generate which is referred to as “Prohibited Income” under IRC 860 Code.

Subprime mortgages

As with subprime lending in general, subprime mortgages are usually defined by the type of consumer to which they are made available. According to the U.S. Department of Treasury guidelines issued in 2001, “Subprime borrowers typically have weakened credit histories that include payment deliquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.”

In addition, many subprime mortgages have been made to borrowers who lack legal immigration status in the United States [1]

Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. Subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranges from 300 to 850. Subprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.

Although most home loans do not fall into this category, subprime mortgages proliferated in the early part of the 21st Century. About 21 percent of all mort­gage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004, says John Lonski, chief economist for Moody’s In­vestors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market[2].

There are many different kinds of subprime mortgages, including:

  • interest-only mortgages, which allow borrowers to pay only interest for a period of time (typically 5–10 years);
  • “pick a payment” loans, for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan);
  • and initial fixed rate mortgages that quickly convert to variable rates.

This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common lending vehicles within this group include the “2-28 loan”, which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR. Variations on the “2-28” include the “3-27” and the “5-25”.

Subprime credit cards

Credit card companies in the United States began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy in the 1990s when usury laws were relaxed. These cards usually begin with low credit limits and usually carry extremely high fees and interest rates as high as 30% or more.[6] In 2002, as economic growth in the United States slowed, the default rates for subprime credit card holders increased dramatically, and many subprime credit card issuers were forced to scale back or cease operations.[7]

In 2007, many new subprime credit cards began to sprout forth in the market. As more vendors emerged, the market became more competitive, forcing issuers to make the cards more attractive to consumers. Interest rates on subprime cards now start at 9.9% but in some cases still range up to 24% APR.

In a very limited number of situations, subprime credit cards may help a consumer improve poor credit scores. Most subprime cards report to major credit reporting agencies such as TransUnion and Equifax, but in the case of “secured” cards, credit scoring often reflects the nature of the card being reported and may or may not consider it. Issuers of these cards claim that consumers who pay their bills on time should see positive reporting to these agencies within 90 days, but they will not commit to that.

Proponents

Individuals who have experienced severe financial problems are usually labelled as higher risk and therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues, usually unforeseen and causing major financial setbacks. As a result, late payments, charge-offs, repossessions and even bankruptcy or foreclosures may result.

Due to these previous credit problems, these individuals may also be precluded from obtaining any type of conventional loan. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to receive loans but pay a higher interest rate and higher fees, may allow loans which otherwise would not occur.

From a servicing standpoint, these loans have a statistically higher rate of default and are more likely to experience repossessions and charge offs. Lenders use the higher interest rate and fees to offset these anticipated higher costs.

Provided that a consumer enters into this arrangement with the understanding that they are higher risk, and must make diligent efforts to pay, these loans do indeed serve those who would otherwise be underserved. Continuing the example of an auto loan, the consumer must purchase an automobile which is well within their means, and carries a payment well within their budget.

Criticism

Capital markets operate on the basic premise of risk versus reward. Investors taking a risk on stocks expect a higher rate of return than do investors in risk-free Treasury bills, Guaranteed Investment Certificates, etc. which are backed by the full faith and credit of the issuing country or institution. The same goes for loans. Allegedly less creditworthy subprime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan.

To avoid the initial hit of higher mortgage payments, most subprime borrowers take out adjustable-rate mortgages (or ARMs) that give them a lower initial interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up charging much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,220. A 6-percentage-point increase in the rate caused slightly more than an 75% increase in the payment.[3] This is even more apparent when the lifetime cost of the loan is considered (though most people will want to refinance their loans periodically). The total cost of the above loan at 4% is $864,000, while the higher rate of 10% would incur a lifetime cost of $1,367,280.

On the other hand, interest rates on ARMs can also go down – in the US, some interest rates are tied to federal government-controlled interest rates, so when the Fed cuts rates, ARM rates go down, too. Most subprime ARM loans are tied to LIBOR (London Interbank Offered Rate – a rate trading system originating in Britain). ARM interest rates usually adjust once a year or per quarter, and the rate is based a calculation specified in the loan documents. Also, most ARMs limit the amount of change in a rate.[4]

The cycle of increased fees due to default-prone borrowers experiencing trouble is a vicious cycle. Though some subprime borrowers may be able to repair their credit rating over time, some default again and may even turn to bankruptcy. While usurious interest rates enhance the profits of subprime lenders, they can also lead to repeated cases of putting consumers in positions they cannot recover from without resorting to bankrupcty.

Mortgage discrimination

Main article: Mortgage discrimination

Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race.[2] Black and other minorities disproportionately fall into the category of “subprime borrowers” because of lower credit scores, higher debt-to-income ratios, and higher combined loan to value ratios. Because they are higher risk borrowers, they are more likely to seek subprime mortgages with higher interest rates than their white counterparts.[8] Even when median income levels were comparable, home buyers in minority neighborhoods were more likely to get a loan from a subprime lender.[2] Interest rates and the availability of credit are often tied to credit scores, and the results of a 2004 Texas Department of Insurance study found that of the 2 million Texans surveyed, “black policyholders had average credit scores that were 10% to 35% worse than those of white policyholders. Hispanics’ average scores were 5% to 25% worse, while Asians’ scores were roughly the same as whites.”[9] African-Americans are in the aggregate less likely to have a higher than average credit score and so take on higher levels of debt with smaller down-payments than whites and Asians of similar incomes.

U.S. subprime mortgage crisis

Main article: 2007 Subprime mortgage financial crisis

Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage defaults and foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation’s second biggest subprime lender.[10] The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole. The crisis is ongoing and has received considerable attention from the U.S. media and from lawmakers during the first half of 2007.[11][12]

However, the crisis has had far-reaching consequences across the world. Tranches of sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless – or impossible to accurately value. Being unable to accurately assess the value of an asset leads to uncertainty, which is never healthy in an investment climate. With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly started facing difficulties or even folding due to the banks’ unwillingness to budge on credit lines.

Observers of the meltdown have cast blame widely. Some have highlighted the predatory practices of subprime lenders and the lack of effective government oversight.[13] Others have charged mortgage brokers with steering borrowers to unaffordable loans, appraisers with inflating housing values, and Wall Street investors with backing subprime mortgage securities without verifying the strength of the underlying loans. Borrowers have also been criticized for entering into loan agreements they could not meet.[14]

Many accounts of the crisis also highlight the role of falling home prices since 2005. As housing prices rose from 2000 to 2005, borrowers having difficulty meeting their payments were still building equity, thus making it easier for them to refinance or sell their homes. But as home prices have weakened in many parts of the country, these strategies have become less available to subprime borrowers.[15]

Several industry experts have suggested that the crisis may soon worsen. Lewis “Lewie” Ranieri, formerly of Salomon Brothers, considered the inventor of the mortgage-backed securities market in the 1970s, warned of the future impact of mortgage defaults: “This is the leading edge of the storm. … If you think this is bad, imagine what it’s going to be like in the middle of the crisis.”[16] Echoing these concerns, consumer rights attorney Irv Ackelsberg predicted in testimony to the U.S. Senate Banking Committee that five million foreclosures may occur over the next several years as interest rates on subprime mortgages issued in 2004 and 2005 reset from the initial, lower, fixed rate to the higher, floating adjustable rate or “adjustable rate mortgage”.[17] Other experts have raised concerns that the crisis may spread to the so-called Alternative-A (Alt-A) mortgage sector, which makes loans to borrowers with better credit than subprime borrowers at not quite prime rates.[18]

Some economists, including former Federal Reserve Board chairman Alan Greenspan in March 2007, expected subprime-mortgage defaults to cause problems for the economy, especially so if US home prices fell.[19]

Other economists, such as Edward Leamer, an economist with the UCLA Anderson Forecast, doubts home prices will fall dramatically because most owners won’t have to sell, but still predicts home values will remain flat or slightly depressed for the next three or four years.[20]

In the UK, some commentators have predicted that the UK housing market will in fact be largely unaffected by the US subprime crisis, and have classed it as a localised phenomenon.[21] However, in September 2007 Northern Rock, the UK’s fifth largest mortgage provider, had to seek emergency funding from the Bank of England, the UK’s central bank as a result of problems in international credit markets attributed to the sub-prime lending crisis.

As the crisis has unfolded and predictions about it strengthening have increased, some Democratic lawmakers, such as Senators Charles Schumer, Robert Menendez, and Sherrod Brown have suggested that the U.S. government should offer funding to help troubled borrowers avoid losing their homes.[22] Some economists criticize the proposed bailout, saying it could have the effect of causing more defaults or encouraging riskier lending.

On August 15, 2007, concerns about the subprime mortgage lending industry caused a sharp drop in stocks across the Nasdaq and Dow Jones, which affected almost all the stock markets worldwide. Record lows were observed in stock market prices across the Asian and European continents.[23] The U.S. market had recovered all those losses within 2 days.

Concern in late 2007 increased as the August market recovery was lost, in spite of the Fed cutting interest rates by half a point (0.5%) on September 18 and by a quarter point (0.25%) on October 31. Stocks are testing their lows of August now.

On December 6, 2007, President Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs by the Hope Now Alliance. He also asked members of Congress to: 1. Pass legislation to modernize the FHA. 2. Temporarily reform the tax code to help homeowners refinance during this time of housing market stress. 3. Pass funding to support mortgage counseling. 4. Pass legislation to reform Government Sponsored Enterprises (GSEs) like Freddie Mac and Fannie Mae.[24]

In late March of 2008, Friedman Billings Ramsey [5] reported the default rate on securitized subprime loans hit 25.2% in December of 2007. Alt-A loan defaults also increased to 8.65%. (The default rate includes loans 90 days or more past due, in foreclosure, and real estate owned.)

See also

  • 2007 Subprime mortgage financial crisis
  • Adverse credit history
  • Hope Now Alliance
  • Negative amortization
  • Carry trade
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