Bad news has been emerging from the subprime market every week, as the trade press reports one lender after another in trouble. As of April 16, 2007, National Mortgage News, a trade publication, counted 32 subprime lenders that had become “defunct” since early 2006.
The good news is that many subprime lenders remain. According to the trade association of subprime lenders (NHEMA), there were 250 member firms in 2005. (NHEMA has since merged with the Mortgage Bankers Association, which is the mainstream trade group). The 32 failed firms accounted for less than 15 percent of the total volume of subprime loans.
However, we don’t know whether the firms remaining are still making loans, and if they are, at what terms. Mortgage brokers are in the best position to answer these questions because they intermediate a large proportion of all subprime loans.
On April 10, 2007, the Upfront Mortgage Brokers Association (UMBA) surveyed its membership on these questions. (I am chairman of the board of UMBA). Of the 55 brokers who responded, five specialized in subprime lending, nine did no subprime lending, and the other 41 did them along with prime loans.
We asked the brokers to describe the changes that have occurred in their wholesale lenders over the last six months. We found that a few brokers with potential subprime clients had lost access to subprime lenders. However, the great majority of brokers have been able to replace defunct lenders with other lenders who were still operating. These were typical responses:
“We lost Fremont, New Century and MLN. We have added BNC, IndyMac and MortgageIT.”
“At one time, I was using as many as eight different subprime lenders for my clients. With everything that has happened over the last six months, I am now down to three subprime lenders.”
One broker said that FHA has been a help filling the void, while another observed that the lenders folding up were being replaced by better lenders.
“The ones that would take any old garbage loan seem to be gone, while the ones where the loan has to make sense are still there.”
The brokers were unanimous in reporting a tightening of underwriting requirements:
- 100 percent loans are much more difficult to find, with the remaining subprime lenders now requiring 5 percent or 10 percent down.
- Stated-income loans, where income is not verified by the lender, are no longer available for subprime borrowers with income derived from salaries or wages.
- Minimum credit (FICO) scores are up by 30-50 points, depending on other characteristics of the transaction.
- Borrowers are being qualified for adjustable-rate mortgages using the fully indexed rate (the most likely rate at the first adjustment) rather than at the discounted initial rate. Regulators have been pressing for this, but the market is doing it voluntarily.
The tightening of underwriting requirements has not been limited to the subprime sector. The requirements in the so-called Alt-A sector, which is an intermediate classification between prime and subprime, are also being tightened. And so are the requirements for “prime.”
Some loans that would have been prime last year will go Alt-A this year. Some loans that would have been Alt-A last year will be subprime this year. And some loans that would have been subprime last year will be rejected this year.
Some brokers who have been in the market for many years remarked that the underwriting rules now emerging are much like those of a decade earlier, before they were swept away by the euphoria created by steadily rising real estate prices. The emerging new rules, which are not based on the inevitability of rising prices, are a badly needed corrective.
Unfortunately, the transition to more restrictive underwriting rules poses a danger to borrowers (and a costly nuisance to brokers). A borrower can begin the process under one set of rules and then have the rules change before the deal is done. Here is a recent example from my mailbox:
“In January, my husband and I decided to build a home. … The mortgage company prequalified us for a subprime loan. … They said as long as we had a 580 middle score by closing, we would not have to have any down payment. A week ago the mortgage company called and said the conditions had changed and now we have to have a 620 or better to close, or else come up with 5-10 percent down. Can they do this to us?”
Borrowers can avoid such costly disappointments by applying the following underwriting rule to themselves: Under the rules now emerging, if you can’t put 5 percent down, have a FICO score below 620 and can’t document the income needed to make the payment on a fixed-rate mortgage, you will probably be rejected. Home ownership is not for everyone.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.