Subprime lending — higher-interest loans to consumers with impaired or non-existent credit histories — has been the fastest-growing part of the mortgage industry.
Subprime mortgage activity grew an average 25% a year from 1994 to 2003, outpacing the rate of growth for prime mortgages. The industry accounted for about $330 billion, or 9%, of U.S. mortgages in 2003, up from $35 billion a decade earlier.The growth has attracted accolades and controversy. Federal Reserve Governor Edward Gramlich has said subprime lenders helped push homeownership to record levels, making it possible for a growing number of minorities to buy homes. But he also raises questions about high delinquency rates.
And dozens of states have passed laws since 1999 to crack down on predatory lending — loans with high fees, excessive interest or other unaffordable provisions — clustered in the subprime sector.
Still, there's no doubt subprime lending is now a Main Street, mainstream business with sophisticated marketing that promises to deliver the American dream of homeownership, or lower the monthly burden of all-too-American consumer debt.
• Ameriquest, one of the nation's biggest subprime lenders, is paying an estimated $15 million to sponsor February's Super Bowl halftime show and became a season-long NFL sponsor. The California-based firm has naming rights to the Texas Rangers' baseball stadium, Ameriquest Field. The efforts are part of a broader move to expand into prime financing.
• Home 123, a subsidiary of New Century Financial, has home improvement guru Bob Vila as a spokesman. New Century Financial's total revenue was up 87% in the third quarter from a year ago. The company expects $40 billion or more in loan volume this year.
• Citigroup, Wells Fargo and H&R Block are among old-line companies that have subprime entities. Major bond firms including Morgan Stanley and Lehman Bros. have a stake in the industry. That's because the bulk of subprime mortgages are packaged into bonds that are resold to investors.
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Amerisave, an online mortgage lender, moved into subprime lending about a year ago, after rising interest rates reduced demand for refinancing among borrowers who qualify for prime mortgage rates.
"We found there was a huge opportunity still in the subprime or less-than-perfect credit area," says David Herpers, chief marketing officer for Amerisave. "Many of these consumers were not able to take advantage of the low rates in the last few years. Our estimates are a third of U.S. citizens fall into this category."
Amerisave has 30 loan officers dedicated to subprime lending. They plan to increase that number to 200 by the end of next year. Amerisave estimates subprime loans will account for at least 50% of the company's total revenue within the next six to 12 months.
Subprime lenders are expected to fare better than the prime lenders as interest rates rise, because their borrowers tend to be less rate sensitive.
Higher-priced products
Even as they push states to pass tougher predatory-lending laws, some consumer groups are working with subprime lenders to deliver credit to borrowers who otherwise could not get financing. And the industry is adopting best lending practices or funding consumer awareness and education campaigns.
Some remain concerned, however, that the industry is selling people higher-priced loans they may not need or be able to handle.
"There are a lot of these people who got the subprime who, if they had shopped more aggressively, would have gotten the prime loans," says Jim Campen, a research associate at the University of Massachusetts Gastón Institute, who works with the Massachusetts Community and Banking Council.
Subprime clients are increasingly being marketed products — zero-down loans, interest-only financing and home equity loans as high as 125% of a home's appraised value — that allow them to buy or borrow, but at an elevated risk.
Like the credit card industry, mortgage companies are pushing their product through television advertising, pop-up ads on the Internet and mailings. While the industry touts its efforts at consumer education, a message of its sales pitch is speed.
"Even if other banks may have turned you down. We don't care — we want to get to know you," says a mailing from Home 123. "We'll get your loan application processed instantly, privately and anonymously over the Internet."
The default rate for subprime loans historically has been well above that of prime loans. The Mortgage Bankers Association says the numbers are improving, with 2.4% of prime loans past due in mid-2004, compared with 10.04% of subprime loans. Those subprime past-due figures are down from 15.67% in mid-2002. Still, 4.61% of subprime loans were in foreclosure in mid-2004, above the 0.49% prime figure.
Growth of the industry
The subprime market has grown for a number of reasons.
Deregulation allowed cross-fertilization between banks and financial service firms, while the federal government in the 1980s lifted mortgage interest ceilings. Congress in 1986 ended the deductibility of consumer debt, such as credit card payments, though still letting filers deduct mortgage interest. The change provided incentives for refinancing. Even rates for subprime loans at 3 percentage points above prime loans, or about 8% to 9% now, are lower than many 18% credit card rates.
Advances in risk modeling have produced standardization. The bond market for subprime loans has provided cash.
The majority of subprime mortgages are now sold by the initial lenders, bundled into bonds and offered to individual and institutional investors. In 1994, $11 billion of subprime mortgages were sold on the secondary market; in 2003, it was more than $200 billion.
"Done right, subprime lending provides an important source of mortgage financing for families with imperfect financial or credit histories," Fannie Mae CEO Franklin Raines said in a recent speech. "Done wrong, subprime lending is a huge rip-off that siphons wealth — and hope — from people who have very little to begin with."
Like the prime mortgage sector, subprime lending is becoming increasingly concentrated, partly because of bankruptcies in the late 1990s when some companies became overextended.
The top 25 lenders made nearly 90% of loans in 2002, nearly double their 1990 market share, according to the Harvard Joint Center for Housing Studies. Ameriquest, New Century Mortgage and National City are among industry leaders. Mainstream lenders are entering the market, but the vast majority of business is done by mortgage firms, thrifts and other entities.
"For a small start-up shop ... it would be harder today to come into this business. In the past you could make a lot of mistakes, and there were very wide spreads. That has gone away," says Laura Swartz, senior vice president of American Mortgage Network, a wholesale firm that sells to mortgage brokers.
The industry is increasingly offering purchase mortgages, though subprime lending is heavily concentrated in refinancing and home equity loans. Firms are targeting potential clients with credit scores and incomes just at the margin needed to easily qualify for a prime loan. They sometimes compete with prime lenders for such loans.
The Fed's Gramlich in a May speech said borrowers with credit scores below 620 are generally viewed as higher risk, unable to get a prime loan without a large down payment. About half of subprime borrowers had credit scores above that threshold, Gramlich noted, indicating "a good credit history alone does not guarantee prime status."
Swartz says borrowers with credit scores of 620 to 640 are the "sweet spot" for the subprime industry.
Consumer groups
The rise of subprime lending presents something of a dilemma for community and consumer groups. Even while they fight for tougher laws against predatory lending, and accuse some firms of reverse red-lining — targeting minority neighborhoods — they are forming partnerships with subprime lenders.
In September, Acorn, a community organization representing low- and moderate-income families, announced an agreement with Citigroup to create an affordable lending program for home buyers, with a special focus on immigrants.
"The partnership with Citigroup had less to do with subprime lending, predatory lending, and more to do with our interest in working with Citigroup and other lenders to extend credit broadly," says Steve Kest, executive director of Acorn. "We see thousands of families who have staked their whole future in this country, have jobs, (but have) only been able to access subprime credit through pretty shady lenders."
Ameriquest, working with consumer groups, is among subprime lenders that have developed best practices for loans, including no loan "flipping" — refinancing at high fees that strip out equity.
While consumer groups and subprime firms have joint interests, disagreements remain. Consumer activists say too many subprime customers are not told they could qualify for prime financing.
New Century, one of the biggest subprime lenders, in testimony to Congress laid out its own internal numbers, which it says underscore that the industry does not overcharge for loans or target minorities. But they also appear to bolster the contention that good credit alone does not guarantee a prime rate.
The firm said slightly more than 19% of its borrowers had credit scores 660 or higher, which lending experts say could easily qualify borrowers for a prime loan, including more than 30% of Asian/Pacific Islander borrowers, 23% of Hispanics, 12% of blacks and 19% of whites. An additional 22% had scores between 620 and 660, which could also qualify them for prime rates, depending on their income, collateral and other financial data, including the ability to make a down payment.
A slight majority of borrowers were white, and on average, New Century clients were under age 50 with annual family income of about $72,000.
Terry Theologides, executive vice president for corporate affairs at New Century, says credit scores tell only part of the story.
"The products that we offer to our highest-credit-grade borrowers are competitive with prime (rates). The spread becomes extremely compressed when you get to those folks," he said, adding the company offered loans with interest rates near 5% to 6% — competitive with prime rates.
The federal Office of the Comptroller of the Currency in a 2002 study said pricing in the industry did not seem out of line with its higher risk. But even a small difference in rates means a big jump in payments. The Harvard Joint Center says a 2 percentage-point difference on an $85,000 loan, a common size for many first-time buyers, adds up to $18,000 halfway into paying off a conventional 30-year mortgage.
Subprime borrowers are far more likely than those in the prime market to take out adjustable-rate loans, and could take a hit as interest rates rise.
Subprime lenders offer products from fixed-rate mortgages to interest-only loans, where borrowers pay just the interest for a set number of years, or 80-20 loans, in which borrowers finance a home with an 80% mortgage at one rate and the remaining 20% through a second loan. Prime lenders also offer such products.
Interest-only products are "very appropriate for a sophisticated borrower, but are they appropriate for a first-time home buyer who has not amassed a lot of equity?" asks Jim Carey, vice president of marketing for AmeriDream, a Maryland non-profit for low-income buyers.
Industry officials say they carefully screen clients to make appropriate loans and avoid defaults that cost the industry money and hurt its reputation.
"If you owned a bank, would you rather be Jimmy Stewart or Mr. Potter sitting in the wheelchair?" asks Mitch Feinstein, National Home Equity Mortgage Association, referring to banker Henry Potter, the villain in the classic movie It's A Wonderful Life.
