Subprime Woes Creeping Up on Prime Servicers

According to the 2008 cost study put out by the Mortgage Bankers Association, servicers did pretty well in 2007, even as the mortgage industry got mired in a crisis fueled by loose subprime lending.

Loan servicing profits rose among predominantly prime credit lenders. Both financial and operating results improved, as servicers saw less portfolio churn that required writedowns of the asset and larger loan balances helped boost servicing fee income. In fact, servicers generated $430 per loan of income from fees and ancillary income last year, up 6% from a year earlier. But those gains were largely generated by the industry's largest firms with portfolios consisting mainly of prime credit quality loans.

In the subprime world, it was a different story. And an MBA economist suggests that some of the woes that have plagued subprime servicing may creep into the prime sector.

Drawing on data from the MBA's 2008 Servicing Operations Study and Forum, Marina Walsh, the trade group's associate vice president for industry analysis, found that subprime servicers faced extreme challenges starting in 2007, most of which persist today. The problem: with few new subprime loans coming in, servicers were left with portfolios of subprime loans that were staying put - and defaulting at record rates. In 2007, subprime servicers saw loans defaulting at an average rate of 24%, according to the MBA. By contrast, the default rate for mega-servicers of prime loans was only 4%. While subprime servicers were mired in default-related woes, the industry's biggest prime servicers saw record operational and financial income from servicing. But the data suggest that the challenges that beset subprime lenders are likely to create headaches for all servicers now and in the future. She noted that default rates were already rising for prime portfolios last year. While the increase was not as alarming as on the subprime side, Ms. Walsh said it serves as a warning sign.

If subprime is a prelude, the prime sector better watch out. The MBA study found that subprime servicers spent an average of $88 per loan in their portfolio on default management last year. By contrast, prime mega-servicers spent just $11 per loan on default management.

A big point of concern is the large volume of pay-option ARMs that will recast into fully amortizing loans over the course of the next few years. The predominantly prime credit borrowers with those loans, which allow negative amortization in the early years of the loan, are facing much higher monthly payments as the loans recast. That is expected to drive up "prime" default rates.

One worrisome sign Ms. Walsh noted: roll rates - the percentage of delinquent loans that roll into a more serious category or default rather than cure - increased for both prime and subprime loans.