The widespread return of the subprime mortgage business will be the big event for the mortgage industry in 2015.
At first glance, this may seem like one of the more wild and outrageous predictions among the widespread prognosticating that happens this time of the year. But it's actually not that crazy, given how the market turned out in 2014.
As origination volume has been shrinking, lenders have been moving down the credit scale. In fact, 31% of closed loans in December 2014 had an average FICO score below 700, according to a sample of Ellie Mae loan data. In 2012, that figure was 21%. And the segment of FICO scores that experienced the biggest increase during that time was the pool of borrowers with scores between 621 and 659.
The subprime market has already seen some recent signs of life, with both lenders and aggregators dipping their toes into the market. And don't forget the lenders out there willing to originate loans that don't meet the qualified mortgage threshold.
The last piece of the subprime puzzle is the return of the 3% down payment conforming mortgages. The conforming product includes mortgage insurance as a credit enhancement, while some lenders, including TD Bank, are also offering a 3% down payment loan program without mortgage insurance.
The recent cut to the Federal Housing Administration's annual mortgage insurance premium could dampen the prospects for the return of subprime, since both products target the same borrower segment. But FHA underwriting is likely to remain very tight, while subprime lending should have (within reason) more flexible underwriting criteria.
There has always been a need for subprime mortgage products. Before the late 1990s through mid-2000s subprime lending boom, lenders were cautious about how they originated these loans and servicers were proactive in making sure borrowers made their payments.
But as more and more people saw the money they could make in this business, they jumped in head-first. The increased competition led to lower credit standards among aggregators and securitizers. Loan officers found originating subprime loans was much easier than FHA lending, which resulted in FHA becoming the product of last resort during the mid-2000s. Underwriting — if the loan even needed documentation in the first place — became lax. And we all know what happened next.
Even though subprime mortgages will fall outside the QM safe harbor, the next generation of subprime lending will still be safer than its predecessors because of ability-to-repay regulations.
Many believe the ATR rule will be crucial to the success of 3% down payment lending and the mandate for lenders to comply with the regulation will do the same for subprime — resulting in a safe, sound and successful alternative mortgage product.
Brad Finkelstein is the originations editor of National Mortgage News.