Confessions of a Subprime Lender

by Richard Bitner

  When Angelo, one of our regular brokers from south Texas, called Ken about funding a potential loan, the key was looking past Angelo’s b.s. and getting to the facts.

  “Hey Ken, it’s Angelo. You got a second?”

  “Sure,” Ken says.

  “Cool. Let me tell you about this deal. I got a guy. He’s a great dude but he’s really had some bad luck. His name is Rock Gonzalez.”

  Translation: “A great dude” meant that Angelo would vouch for his character. This meant nothing since Angelo was less than punctual when it came to paying his own bills. “Bad luck” could mean anything, but in this case the borrower had trouble holding on to a job for more than 6 to 12 months. Angelo faxed over the loan application and credit report for prequalification, and Ken determined the loan was a run-of-the mill deal: Rock had barely okay credit, but still qualified for a mortgage with no money down. We approved the loan, and 30 days later the deal closed. That’s when things started to go sideways.

  Keep in mind that we knew none of the following information before funding the loan; everything during the due diligence process was either misrepresented or not disclosed.

  It turns out that Rock, an ex-con, operated a business with the seller of the property, Cindy, who was also his girlfriend. He maintained a separate apartment but spent most of his time living in her home, the same house he was trying to purchase. They had two objectives for conducting the transaction. Cindy was two months behind on her mortgage and desperately needed to catch up. They also wanted to infuse some cash into their business. Although Cindy had built up a little equity in her home, she wasn’t able to refinance because of her poor credit. By selling the home to Rock, she could pay off the mortgage, get some cash, and her problems would be solved. If only life were that simple.

  Angelo had known Rock for several years having met him at the local gentlemen’s club. What Rock didn’t know was that Angelo had a thing for Cindy but just couldn’t get up the nerve to tell anybody. Occasionally, Angelo and Cindy would mildly flirt with each other, but Cindy tended to flirt with everybody. After a while, Angelo made himself believe that she felt the same way about him as he did about her. That was a big mistake.

  Once the loan finally closed, he decided to make his move. When Cindy refused his advances, Angelo was stunned. He went home and proceeded to drink himself into a stupor. The more he drank, the angrier he became. Finally, he picked up the phone and called Cindy, threatening her life.

  When Cindy told Rock what happened, he shrugged it off. He thought that Angelo was harmless. But when Rock jokingly suggested Cindy should go out with Angelo, Cindy went crazy. She grabbed a baseball bat and started taking swings at his head. Rock bolted from the house. According to Rock, Cindy threatened to “cut off his nuts if he ever set foot in the house again.”

  Keep in mind that Cindy was no longer the owner of the property, which created an interesting shift. With Rock not living in the house that he had just purchased, he quickly lost the motivation to make the mortgage payment—leaving Kellner stuck with a fraudulent, nonperforming loan.

  While this scenario was playing out, we’d already sold the loan to our investor, who promptly required us to buy it back. We had to threaten to report Angelo, Rock, and Cindy to the Texas Attorney General’s office before we could get any cooperation from them, but we eventually worked out of the mess after Rock sold the property and the loan was paid off.

  Angelo later called Ken in our office one afternoon, drunker than a skunk, promising to make it up to him for getting us in trouble with our investor. He never did. Of course, given how drunk he was at the time, it’s unlikely he would have remembered ever making the phone call.

  This deal had a little bit of everything: the broker misrepresenting the borrower, the borrower misrepresenting himself, the seller misrepresenting herself, a fraudulent loan application, a misrepresented appraisal, a falsified verification of employment. It was more extreme than the typical fraudulent loan, but it was typical of the type of transaction that tended to walk through our door.

  I graduated from an Ivy League university believing that one day I would swing for the fences and make it to the big leagues of corporate finance. This loan made me realize that somewhere along the way I’d made a wrong turn. As a subprime lender, I felt more like I was playing in the bush leagues.

  The Business of Subprime Lending

  Since the current housing fiasco is tied directly to the subprime industry, it’s easy to believe that lending money to borrowers with damaged credit is a bad idea. One newspaper columnist argued that financing subprime borrowers should never have been allowed in the first place. It’s an understandable reaction given the rising number of foreclosures, but a closer look at the performance of subprime loans supports a different viewpoint.

  Even though mortgage delinquencies are hitting record highs, the vast majority of subprime borrowers are making timely mortgage payments. Admittedly, overall delinquencies are far too high, but the fact that most borrowers are making payments means that lending money to credit-challenged borrowers is not a totally flawed proposition. The issues we’re currently facing are a function of a much deeper problem—one that goes to the heart of how the industry operated.

  To understand subprime lending, we must explore the mechanics of the industry—how and why it functioned as it did. The rest of this chapter will describe the profile of the subprime borrower, trace the evolution of subprime lending from its beginnings in the 1980s through its first crisis in the 1990s, examine the players and their motivations, and explain the unique subculture of the industry. Once this foundation has been established, we can examine the business in greater detail.

  Subprime Borrowers and Credit Scores

  Subprime borrowers are unable to qualify for conventional or conforming mortgages because they have less than perfect credit, usually because they’ve made late payments or defaulted on previous debt. These borrowers pay a higher interest rate and loan fees to offset the increased risk.

  Borrowers can be classified as subprime because of income or employment issues, but the main reason is usually damaged credit. The most important part of a borrower’s credit profile is the credit score. Understanding what it means and how it’s used is vital to developing a customer profile.

  A credit score is a measure of a person’s credit risk, calculated using the information from their credit report. These scores, which range from 300 to 850, are compiled by credit bureaus, companies that collect and sell information about each person’s credit worthiness. The three largest credit bureaus in the United States are Equifax, TransUnion, and Experian.

  Credit scores are commonly referred to as FICO scores, which is an acronym for the Fair Isaac Corporation. A FICO score is a specific credit score issued by the Experian credit bureau. Equifax and TransUnion also used Fair Isaac to develop their own proprietary scoring models. Although a borrower has only one true FICO score, the acronym is commonly used as the generic term for credit score.

  Borrowers with scores above 620 are classified as conforming (they conform to Fannie Mae or Freddie Mac guidelines) or Alt-A. Both require good credit, but Alt-A loans have other variables, such as a borrower who qualifies without having to prove income. Subprime borrowers have credit scores from 500 to 620; potential borrowers with scores below 500 are unable to qualify.

  Though credit scores largely determine the loan type, there are exceptions. A borrower with a 640 credit score and a recently discharged bankruptcy might be considered subprime, while a borrower with a 580 credit score and compensating factors could qualify for a conforming mortgage. Chapter 4 explores the subject of credit in greater detail.

  Types of Subprime Borrowers

  There are no official definitions for what constitutes a subprime borrower, but most can be described in one of four ways:1. Slow to Pay. These individuals have a history of paying their creditors late. This category represents the bulk of all subprime borrowers.

  2. Underqualified
. These consumers have little credit history, so they’re unable to earn a good credit score. Many borrowers don’t realize until they apply for a mortgage that having little or no credit can be worse than having poor credit.

  3. Life Challenged. Borrowers who face a traumatic event, such as a divorce, failed business, or medical problem, can experience income or credit challenges as a result. This can prevent them from getting a low interest rate.

  4. Unlucky. This can describe two types of borrowers. The first are those who are not habitual credit abusers, but whose credit score has dropped because of an unusual circumstance (such as forgetting to pay bills while away). The second are borrowers whose credit is on the cusp between conforming and subprime. If they choose the right broker or lender (someone looking out for their best interest), they qualify for a conforming rate. But if they choose the wrong person, they get a subprime mortgage.

  Until 1998, home prices and income increased in relative proportion to each other, which meant housing affordability remained largely unchanged. Over the next 10 years, the balance between the two became skewed. While income grew marginally, home prices sky-rocketed, which created an affordability gap. With more homebuyers struggling to qualify, a new type of subprime borrower emerged:

  High Risk. These borrowers faced two challenges in purchasing a home: no down payment, and not enough income to qualify. The development of new subprime loan products to serve the needs of these borrowers greatly contributed to the industry’s demise.

  The Evolution of Subprime Lending

  Subprime lending has no official start date, but three events paved the way for the industry’s formation.• The Depository Institutions Deregulation and Money Control Act (DIDMCA) of 1980 made the subprime business legal by allowing lenders to charge higher rates and fees to borrowers.

  • The Alternative Mortgage Transaction Parity Act (AMPTA) of 1982 allowed the use of variable interest rates (ARMs) and balloon payments.

  • The Tax Reform Act (TRA) of 1986 prohibited the deduction of interest for consumer loans but allowed it for mortgages on a primary residence, increasing the demand for mortgage debt. When deductibility was factored in, even high-cost mortgage debt was a better option than consumer debt.

  Although these changes helped launch the industry, two market-driven events contributed to the initial growth phase. First, by late 1993, the industry was coming to the end of a refinance cycle. With interest rates going up, loan volume in the conforming market was shrinking. To fill the void, brokers and lenders began originating subprime mortgages.

  Second, Wall Street investment firms began securitizing these mortgages. Securitization is a process where thousands of mortgage loans are bundled together into financial products called mortgage-backed securities (MBSs). These investments are secured by the principal and interest payments made by consumers. The process, which already existed for conforming and Alt-A mortgages, created an end or secondary market for the product.

  While working at RFC, I bought subprime loans from Tony DeLuca, viewed by many as the first subprime mortgage company in Texas. He explains the impact that securitization had on the subprime market.

  When I started in 1989, there was no secondary market for these loans, which meant I had to use a private investor. Since our investor paid us nothing for the loans, the only profit we made came from the fee we charged the borrower.

  In 1993, my investor ran into a problem, which forced me to find another source. The next day I went searching online and found a company called Equicon that wanted to buy my loans. They came to my office, underwrote the loan files, and paid me a premium for the first time. This redefined the business. Overnight, we went from having to charge the borrower to make a profit, to paying brokers a premium the way the industry does today.

  The process of packaging mortgages into securities turned these illiquid assets that could not be easily sold into liquid ones. With a secondary market to trade them in, investors quickly developed an appetite for buying these high-yield securities. The increased demand meant companies like Equicon paid lenders a premium to acquire them.

  The Economics of the Business

  As the appetite grew for these securities, so did the price to purchase the mortgages. By 1994, investors were paying upwards of 700 basis points (bps) per loan, or 7 percent of the loan amount. Even a small company had enormous profit potential: A total monthly volume of $10 million, multiplied by 7 percent (700 bps), would result in a gross profit of $700,000. With 300 bps ($300,000) in total costs, a subprime lender could earn $400,000 in monthly net revenue. To be able to produce this income with fewer than 50 employees was phenomenal.

  To feed the increased demand for the securities, investors began to relax the underwriting guidelines, which enabled lenders to extend financing to more credit-challenged borrowers. Tony DeLuca describes the events that repeated themselves a decade later.

  By the mid-90s, investors really got an appetite for subprime and started getting aggressive with what they bought. For a while, ContiMortgage, my main investor, was buying every mortgage we showed them, even the loans that didn’t fit their matrix. It didn’t matter how rough the loan was, they always bought the loan. After a while we started to joke their program guidelines were more like suggestions since the underwriters didn’t follow them anyway.

  The First Crisis—1998

  In 1998 Long Term Capital Management (LTCM), the well-known hedge fund of Salomon Brothers bond trader John Meriwether and Nobel Prize-winning economists Myron Scholes and Robert Merton, ran into problems. Like many hedge funds, they based their investment strategy on a mix of foreign bonds and currencies. While the strategy forged by the economists was rather complex, it didn’t take into consideration that a market could behave irrationally. When Russia looked like it would default on its debt, a crisis ensued.

  Because the investments were highly leveraged, the fund quickly lost half its value. With a large number of banks and pension funds invested in LTCM, the impact was significant. There was serious concern at the time about whether the problems could bankrupt these institutions. In a bold move, Federal Reserve Chairman Alan Greenspan convinced the banks to remain in the fund, which averted disaster. By lowering the Fed Funds rate, the interest rate banks charge each other for overnight loans, he also sent a powerful message: The Fed would take whatever action was necessary to avoid catastrophe.

  With investors retreating to safer investments, the secondary market for subprime mortgages dried up. When fewer investors were willing to purchase these loans, the industry experienced a major shakeout. Many of the top 25 players quickly went out of business, and the rest either merged or failed shortly afterward.

  While the 1998 crisis has similarities with the current one, there are some differences. John Mauldin, President of Millennium Wave Advisors, made an excellent comparison in his August 11, 2007, article, “Back to the 1998 Crisis, Subprime to Impact for a Long Time.”

  In 1998, problems in Asia and Russia spread to the rest of the markets, affecting US stocks. It took a few months to sort out, and a lot of people lost money. Today, problems in the subprime mortgage markets spread to other credit markets and the effect is spilling over into the stock markets. But there is a difference. Today, instead of one fund that was the epicenter of the problem, the problems are spread around among scores of funds and permeate the largest institutional and pensions funds. While that means the losses are spread among thousand of investors, it also means that central banks can’t bring everyone to the table to fix the problem. . . . And one last difference between 1998 and today. Back then, the problems in the market became known and were priced into the markets in relatively short order. It’s going to be several years before we know the extent of the subprime losses.

  With many investors having lost their appetite for high-risk mortgages, the market experienced a major pricing correction. Overnight, lenders went from making 700 basis points down to 300 to 400. As months passed and the market stabilized, pric
es eventually leveled at 500 bps. For those lenders who survived the crisis, subprime lending still remained a viable business opportunity.

  Understanding the Players and the Process

  To understand mortgage lending, you must know the players, their roles, and their motivations. Figure 2.1, the mortgage industry “food chain,” breaks down the lending process by identifying the industry segments and their functions with arrows showing the path a mortgage follows.

  When consumers need a mortgage, they can use either a mortgage broker or a mortgage lender/banker. Brokers only originate the mortgages, while lenders close the loans in their own name, using their own funds.

  Since loans must be securitized in large quantities, most lenders like Kellner Mortgage rely on bigger lenders, companies like GMAC and Countrywide, to purchase loans from them. In turn, these companies aggregate the mortgages from numerous sources before securitizing them. Since we sold loans directly to these larger lenders, I’ll refer to them as investors throughout the book.

  What happens next depends on the type of loan. If the loan is a conforming or prime loan, it gets sold to Fannie Mae or Freddie Mac. These government-sponsored entities (GSEs) package the loans into mortgage-backed securities (MBSs). If the mortgages don’t meet the guidelines established by the GSEs, lenders use investment firms to package them into nonagency MBSs. Excluding home equity loans, there are three types of nonagency MBSs: Jumbo A, Alt-A, or Subprime. The institutions that purchase the MBSs range from hedge and pension funds to foreign investors. The sale of these securities is dependent on the rating agencies, companies like Moody’s and Standard and Poor’s. They provide judgments about whether these investments will pay interest on schedule until they mature. They rate the securities with a letter grade (AAA to BB-) to indicate the level of risk associated with the investments. Since this book focuses on the subprime industry, government loans (FHA and VA) have been excluded from the chart.