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The Future of Subprime Lending

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By Amy Hoak, MarketWatch

RISMEDIA, Oct. 23, 2007-(MarketWatch)-Although “subprime” has become a four-letter word in the country’s collective lexicon and no one is sure when the credit crisis that was spawned by a meltdown in the risky lending sector will ease, mortgage bankers say you can count on this: Subprime shall return.

The next generation of subprime mortgages, however, will look much different than the loans issued during the height of the housing boom in the first half of the decade that are now causing so much trouble, mortgage professionals say.

“So long as we have a policy position in this country of maintaining or further increasing homeownership rates there is going to be subprime lending,” said Mark Fleming, chief economist with First American CoreLogic, a provider of mortgage-risk management and fraud-protection technology.

“We have been very successful in increasing homeownership rates. One of the ways we’ve done that is by creating liquidity and offering credit to people who we traditionally wouldn’t have 20 years ago — the subprime borrower.”

Fleming was one of 4,300 mortgage professionals who traveled from around the country to Boston this week for the industry’s annual convention, where participants did a lot of reflecting on the lead-up to the credit crunch this summer and the housing slump pervading many of the nation’s real-estate markets.

Many are looking to the Federal Housing Administration to step into the subprime void. Several proposals in Congress would expand FHA lending authority, allowing it to come to the rescue of subprime borrowers struggling with their current mortgages.

The FHA, which provides government-backed mortgage insurance on low-down-payment loans, is in a good position to address the subprime market, Fleming said, even though the growth in private-investor-backed subprime lending “directly cannibalized the FHA business. FHA went down and subprime went up.”

That said, subprime mortgages backed by nongovernment investors will also return — albeit with greatly different lending standards than in recent years, some in the industry say. Translation: It won’t be the “Old Wild West” again, where mortgage money came easily for all types of borrowers, said Thomas P. Cronin, vice chairman of Clayton Fixed Income Services, a credit-risk management firm.

“But it (subprime lending) will come back in a mature and rational fashion, as markets tend to do,” Cronin said.

Rebound still a ways off

Certainly, that return isn’t happening just yet. According to data from Clayton, nonconforming securitizations were down 82% between December 2006 and August 2007. Nonconforming loans are those that can’t be purchased by government-sponsored mortgage agencies Fannie Mae or Freddie Mac, which are limited to buying loans of $417,000 or less.

Jumbo loans, those above the limit, and most subprime loans rely on the private-securities market for liquidity.

“[Subprime] volumes are way off from where they were even a year ago,” said Steve Nadon, president and chief operating office of Option One Mortgage Corp., during a MBA panel discussion. But Nadon thinks that the subprime market will indeed return. “Will we serve as many borrowers as before? Maybe not,” he said.

Hard-working people with limited income or blemished credit histories deserve and need access to credit, but the terms should be fair, said David Beck, policy director for Self-Help, a community-development lender that makes fixed-rate loans to credit-blemished borrowers. Self-Help’s affiliate, the Center for Responsible Lending, is a vocal policy organization with a mission to protect homeownership and eliminate abusive financial practices.

“It used to be the problem was access to credit. Now it’s the terms of credit,” Beck said.
“There’s a line between providing fair access to credit and taking advantage of people.”

To start, Beck said prepayment penalties should be prohibited on subprime loans. He also thinks that there should be more of an effort by conventional lenders to figure out which of these subprime borrowers eventually could be moved into prime products.

Subprime lending shouldn’t dry up completely, it’s the “abusive products” that should dry up, Beck said. Before putting a borrower into a loan with an interest rate maybe one percentage point above the prevailing conforming rate, Self-Help spends a fair amount of time with clients to make sure they can make the monthly payments, he said.

While FHA reform might help some of these borrowers, it’s hard to say how much, he said.

Regaining investor confidence

For subprime products to come back to the market with any significance, it’s necessary to first build up the confidence of those who invest in them, Fleming said.

Some investors have been beginning to return in the past couple of weeks, Fleming said. He expects that the prime jumbo loan market could be the first to make a return to some kind of normalcy, but there is a long way to go before the nonconforming market could be considered stable.

How will the confidence be fully regained? For one: “We have to do a better job of making sure a high percentage of the loans aren’t headed for default to begin with,” Cronin said. As such, subprime mortgage products need to be redefined, he said. As people got caught up in the euphoria of home-price appreciation, “we got away from balanced credit decisions,” said Michael McQuiggan, CEO of Tri-Emerald Financial Group, a mortgage lender and processor, during the MBA panel discussion.

“People that probably shouldn’t have had those homes in the first place had gotten away with it for years because of home-price appreciation,” Cronin said. Suddenly, when they couldn’t refinance those loans, problems started surfacing and foreclosures became imminent.

Now, there has been a shift back to basics across the entire mortgage lending spectrum, using more reasonable assessments of what buyers can afford, Fleming said. People now need better credit scores and a larger down payment to get a mortgage, in addition to documenting their incomes and proving where they work, he pointed out.

For those in the mortgage industry, there should be a return in focus to the writing of quality loans — not just doing a large quantity of them, Nadon said. And perhaps part of the lender’s mission should also be helping subprime borrowers graduate into prime loans, he added.

Beyond that, there have been calls for more transparency in the market, and suggestions that the risks of investing in mortgages should be completely understood at the outset. “We need to sort out in the industry how we assess risk and provide signals as to how risky these things are,” Fleming said.

Plus, investors and lenders also need to be more responsible in how they approach leverage, Cronin said.

It was leverage, after all, that exacerbated investor losses, Doug Duncan, chief economist of the Mortgage Bankers Association, said during a briefing with reporters earlier this week.

“Subprime was clearly the trigger, but it was the old standard that leverage works well when asset values are going up to increase return on equity; but when asset values are going down, it works adversely to exhaust equity,” he said.

Amy Hoak is a MarketWatch reporter based in Chicago.

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