Bright, shiny objects are hard to resist. Like the glowing orb cast by the anglerfish – the last thing its prey sees before the deadly bite – subprime lending is back with the potential for profits shining like a beacon. There are several ways for lenders and investors to grab a piece of the action, but are the latest moves tempting a fate similar to 2007?
There's smoke . . .
Although the housing market has been a relative sea of calm in recent years, the mortgage market has slowed down. Interest rates are on the rise, housing inventory is low and in certain markets, home prices are back to their peak levels or beyond. The housing market appears headed for a decline, and the severity of the fall may depend on just how high interest rates go. If a threshold is crossed, after which interest rates choke off further borrowing and further depress home prices, some are bound to be caught in the crosscurrent of riskier mortgages and declining home equity. We've seen this before.
. . . but will there be fire?
Although some banks, like Wells Fargo and JPMorgan Chase, are following traditional paths of securitizations and warehouse lending, others are creatively partnering with non-profits, such as, the Neighborhood Assistance Corporation of America (NACA) to finance non-prime borrowers. Regardless of approach, one of the keys to performance will be following a different approach in order to get a different result than the last time around.
Approximately half of the home loans in the United States are originated by nonbanks, many of which rely on funding from banks to make subprime or non-prime loans. Visibility into this financing (known as warehouse lending) is often lacking given that many of the recipients are not publicly traded, but it's been observed that loans originated by nonbanks are generally of a lower credit quality than those originated by banks and thus would be more vulnerable to delinquencies triggered by a fall in housing prices. Banks providing warehouse financing continue to risk being on the hook, if there is another downturn. However, the cushion provided by warehouse lending, including advance rates and additional collateral, can make it less risky for them than direct lending.
For the 2018 Wells Fargo securitization, it's a very different kind of pool than we saw a decade ago. This new pool is considered high-quality, composed of conforming loans from high-cost markets and jumbo loans. According to Moody's, they are all qualified mortgages, from borrowers with high FICO scores, significant cash reserves and "perfectly clean pay history." Although there are exceptions to the underwriting guidelines that have been waived due to compensating factors, they are considered minor by the due diligence firm conducting the review.
Partnerships with non-profits
Even with potential dangers mounting, there are ways to tap the subprime market directly and manage the risks. For example, it's been reported that Bank of America and CitiMortgage have pledged $13 billion in loan commitments to back the NACA program. To become a potential borrower, members must go through a rigorous counseling program that teaches them about finances and imposes a budget to ensure they can afford the mortgage. These borrowers may be a risk based on past financial struggles, but they are considered to be highly invested in doing the work to rehabilitate their past credit or prepare for the responsibilities of home ownership, which makes the risk more manageable.
The potential rewards of serving the subprime market should continue to attract investment, and, at the same time, the stinging memory of subprime's past should spawn creative ways to manage the risks. This creativity and adjustments in practices should help avoid any widespread disaster, if the housing market sinks.
In fact, we would look elsewhere for a fire – somewhere past success hasn't required the reckoning that has shaped the secondary mortgage market. Somewhere the current weakness in the underlying collateral market is a combustible mix with riskier lending practices – subprime auto.
Seiji Newman, a Counsel, and Nicole Serratore, an Attorney, in the Insolvency, Creditors' Rights & Financial Products Practice Group of Davis & Gilbert each contributed to this post.
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