Why Subprime Lenders Are In Trouble


New analysis suggests that subprime lenders lowered their lending standards last year as they competed for business

As the subprime mortgage market goes into steep decline, threatening to drag the whole economy along with it, many people are wondering what could have gone so wrong so quickly. Until recently, after all, delinquency and foreclosure rates on subprime loans were reassuringly low.

The answer may lie in how the quality of these mortgages has changed over the years. While subprime is the term used for loans issued to people with poor credit, not all subprime loans are created equal. And the subprime loans that were originated in 2006 that are turning out to be shockingly weak.

Why 2006? What happened last year that caused credit quality to go into steep decline? Michael Youngblood, head of asset-backed securities research at Friedman, Billings, Ramsey Group (FBR) in Arlington, Va., has been poring over the data. He points out that there was a sudden but little-noticed shift in lenders' strategy that occurred at the end of 2005: Lenders went from competing for customers on price (by lowering rates) to competing for customers on easy terms (by lowering lending standards).

Undisclosed Change

The change was little-noticed, says Youngblood, because the lenders actively denied it. "To my disappointment as a long-time analyst," says Youngblood, the major lenders insisted that they had not lowered their credit standards long after they had begun to do so. "I met with all of the public subprime lenders in early June…to a man they swore they had maintained 2005 origination volumes…without sacrificing credit quality. Like a dope, I sat there and didn't challenge them."

There's been a rush of bad news in recent weeks. On Feb. 8, HSBC Holdings (HBC) and New Century Financial (NEW) both reported troubles in their subprime portfolios (see BusinessWeek.com, 2/9/07, "Subprime Time Bomb"). Then on Feb. 21, NovaStar Financial (NFI) reported quarterly financial results that staggered analysts with the range of bad news, including the possibility that the company will have no taxable income through 2011 (see BusinessWeek.com, 2/22/07, "A Painful Hiss from the Subprime Balloon").

Lenders, many of them facing shareholder lawsuits, have been reluctant to answer questions about their lending standards. New Century, one of the biggest, declined a request from BusinessWeek for an interview on the topic.

Paying for 2004's Rate War

The root of the trouble actually stretches back to 2004. In a battle for market share, the subprime lenders began cutting rates. This rate war actually improved the credit quality of their loan portfolio because the low rates attracted people with good credit scores who otherwise might have gotten loans from prime lenders, says Youngblood. In fact, he says, the average FICO score of subprime loans made in 2005 was the highest ever.

Trouble was, those low rates weren't very profitable, especially because the Federal Reserve was jacking up the lenders' cost of funds at the same time. Their interest-rate spread—the key to their profitability—shrank from nearly 6 percentage points in 2003 to just over 3 percentage points by the end of 2005. That wasn't enough.

To resuscitate profits, the subprime lenders started raising their lending rates. Naturally, though, that chased away customers. But Youngblood says the lenders weren't willing to shrink their volume of business, which would have required massive layoffs and probably would have caused a big hit to their stock price as investors reassessed their growth potential. To keep volumes up, says Youngblood, the lenders started making thousands of exceptions to their underwriting guidelines—so many that the published guidelines became the exception more than the rule. Says Youngblood: "The lack of overt changes in underwriting guidelines allowed the industry covertly to adjust its underwriting standards."

The higher rates improved profitability—but not for long. Soon, loans to people with weak credit started going bad at an alarming rate. And the buyers of the loans started exercising their right to sell the bad ones back to the lenders at face value. The true value of these delinquent or foreclosed loans was far less than face value, but the lenders were forced to swallow the difference.

"Game of Chicken"

At this stage, Youngblood says, subprime rates are high enough again that the industry can actually be profitable as long as lenders make prudent lending decisions and don't chase after volume. But the pool of foolish loans they made in 2006 will continue to haunt them for some time to come, he says.

Other industry analysts, while not agreeing with Youngblood on all points, also say that the 2006 debacle resulted from lenders' chasing volume by relaxing underwriting standards. "You had two choices: relax your standards or lose business," says Robert Lacoursiere, a Banc of America Securities (BAC) analyst. "It was a giant game of chicken."

Youngblood is disgusted by the whole thing: "Basically the Keystone Kops were making loans," he says. "Or, to change the metaphor: Every time they see a sword they want to throw themselves on it."

Coy is BusinessWeek's Economics editor.

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