A Primer for the Subprime Problem

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From Standard & Poor's RatingsDirect

Historically, subprime mortgages have represented 10% to 12% of the total mortgage market.

Can the standalone specialty mortgage finance lender survive?

Yes, if its lending is diversified across a broad spectrum of the mortgage market. Those companies with diversified mortgage lending and servicing operations, aligned with strong interest-rate and credit-risk management oversight, can survive the shakeup. Some specialty-finance companies that successfully lend to all segments of the mortgage market have multiple origination and sale channels. Not surprisingly, these are the organizations that perform better through varying credit and interest rate cycles.

Another indicator of a mortgage-banking operation built to last is one with a strong mortgage-servicing business, which is a fee-generating business and provides a hedge to the cyclical mortgage-production business. A strong servicing business also provides a critical infrastructure for growth in mortgage production.

The specialty-finance lenders that aren't part of a bank—and thus can't rely on deposits for at least partial funding—face great liquidity and funding challenges. Instead, their growth depends on access to the capital markets and third-party funding, such as mortgage-warehouse lines. Critical to keeping these funding lines open are capital strength and good credit quality. Once these two critical measures deviate from their expected paths of performance, the access to funding weakens, and in extreme cases, such as that of New Century, is shut down.

Did subprime lenders lower their lending standards dramatically in the past 12 months?

Some did. The risk layering of mortgage underwriting we refer to above is evident of the lower lending standards. Also, the wider acceptance of nontraditional mortgage products (such as interest-only loans) by consumers, lenders, and investors added to the shift in higher credit risk for subprime mortgages.

The growth of these products and loosened underwriting standards prompted U.S. bank regulators to tighten standards on Oct. 4, 2006. Even more recently, on Mar. 9, 2007, the Federal financial regulatory agencies issued a proposal calling for raising standards for qualifying borrowers and requiring more detailed disclosure of loan costs to prevent predatory lending practices.

Subprime mortgage lenders often sell most of their loans to investors. Can we expect institutions that buy subprime loans to stay away from these investments for a while? What about organizations that lend to, insure, regulate, and securitize subprime lenders—will they stay away now?

The slowing real estate market and the spike in early-payment defaults on some subprime mortgage loans have naturally made buyers more cautious, which will dampen loan volumes. Clearly, the subprime loans out of favor with investors and Wall Street buyers are the 100%, or high loan-to-value loan, with no stated income and no stated asset verification. Specialized subprime lenders will continue to originate only those loans that can be sold to the secondary markets, as they tend to not be portfolio lenders. The majority of their volume is "presold," or tailored to specific buyers/investors of their loans.

We expect some financial institutions that provide mortgage warehouse financing to specialty mortgage lenders to either exit this business or reduce their volume of financing during the next year. The degree of exodus will depend on the financial institutions' commitment to the business, as well as other business relationships they may have with the lenders they're financing.

When will the subprime market stabilize?

We anticipate stabilization by the end of 2007, but the ultimate timeline will depend on the broader economic trends in the U.S., including market interest rates, unemployment, and regional housing trends. When loan volumes decline, the profitability challenges for specialty-subprime lenders proliferate.