Does Subprime Have a Future, and If So, What?
Let's take a stroll back in time to my childhood. It's the early 1970s and I'm watching a Yankees game on WPIX in New York. (I'm a Mets fan but I occasionally take in a Bronx Bombers game.) At the commercial break I see Yankees broadcaster Phil Rizzuto talking about something called "The Money Store."
As I recall, Phil is standing in front of a window of what must have been a retail branch of The Money Store. He's telling viewers that if they need cash, they can borrow it by taking a mortgage out against their home. I was a teenager but I still remember that commercial. Why? Because of Phil Rizzuto. How could you not remember and love Phil? He was always saying hello to Mrs. McGillicutty who lived on 223rd Street in the Bronx. That's the kind of guy he was. You trusted him.
Let's zoom ahead to the late 1990s. By now The Money Store is a publicly traded subprime giant. It funds loans through retail and wholesale channels and is a top funder of B&C loans. In the late summer 1998, the Russian debt crisis strikes and the subprime industry melts down -- in part because of the bond market panic but also because of abuses on "gain-on-sale" accounting where subprime securitizers are allowed to book tomorrow's profits today.
In March 1998 -- before Russia's default -- a large money center bank called First Union bought TMS, paying close to $2 billion for the company. Within a year or so First Union wrote off the entire value of TMS, and within two years shut down most of its production platforms. What a disaster!
And here we are in the fall of 2007. We have no Russian debt crisis, but a costly war in Iraq and a huge federal budget deficit. The subprime industry is coming off its five best years ever -- that is, up until the first quarter of 2007.
In 2006, subprime production ($674 billion) accounted for 21% of all loans produced in the U.S. In the second quarter of 2007, mortgage bankers originated just $59 billion in A- to D credits, or 7% of all loans. From December 2006 to September 2007, some 120 or so mortgage bankers that specialized in subprime closed their doors.
The future of subprime looks bleak indeed. Beginning in 2002, Wall Street began "pumping up" the sector by extending warehouse lines to B&C funders, buying the same loans they were warehousing, and then securitizing the underlying mortgages into bonds. Early on, Wall Street didn't pay much attention to the credit quality of the loans they were buying, relying on the contractual obligation of the originator to "buy back" any early payment defaults.
Who says Wall Street didn't pay much attention to underwriting? Ed Jones, president and CEO of ARC Systems of Austin, Texas. ARC markets underwriting software to lenders and investors. The software, according to Mr. Jones, analyzes loan quality. He told us recently that over the past two to three years ARC's software was kicking out 30% to 40% of mortgages slated for inclusion into loan pools.
When Mr. Jones and ARC pointed this out to certain Street firms, their response (according to him) was: "So, what. We'll just put it back to the lender." Indeed, Wall Street has. And now we have a liquidity crisis, a subprime meltdown and a mortgage market "correction" that is leading to thousands of job losses in the industry. We have declining home sales, declining home prices and no secondary market for nonconforming.
It's an ugly stew indeed. So, is there a future for subprime? The short answer is yes. The difficult answer is how do we get there? I would suggest that we might return to the days of yore when subprime lenders based their underwriting decisions on "home equity" and not a computer program that spits out FICO scores. Back then subprime wasn't called subprime. It was called B&C, hard money or home-equity lending.
When the subprime sector rises from its current ashes, chances are it will be much smaller, more conservative, and one where loans are held in portfolio and not securitized or financed through Wall Street. Make no mistake about it: Wall Street's days in this industry are numbered. What's needed are market professionals you (and the public) can trust -- someone like, say, Phil Rizzuto. Of course, Phil is no longer with us but Mrs. McGillicutty and her daughter are still living on 223rd Street and they might need a home-equity loan. Remember that word: "equity." Without it, there is no future for subprime.
Paul Muolo is executive editor of both Mortgage Servicing News and National Mortgage News. He can be e-mailed at Paul.Muolo