Subprime mortgage lending can be a high-margin business, but danger lurks everywhere. Green Tree just got hit hard on prepayment risk, but I believe the real risk in the sector is a giant firestorm of credit risk to those who are not prudent in their lending policies.
The mortgage lender struggling to make one point per loan is understandably drawn to a product where obtaining 4 or 5 points from the borrower is typical.
Unfortunately, I already see a decades-long mortgage banker obsession with volume sneaking into the subprime arena. During my 20 years in the industry, I have been constantly amazed at the typical conversation between mortgage bankers: "How's business?" one lender asks another. "Terrific!" comes the response, "Volume's never been better."
It has always astonished me that mortgage lenders rarely answer by discussing margins, earnings, or returns on capital. Somehow, lenders never want to talk about their delinquencies. Somehow, volume is all that matters.
Unfortunately subprime, a still-great business, is being infected by the mortgage banker mentality that volume is the altar to be worshiped at. Securities analysts may inadvertently fan the flames by being attracted to companies with top-line growth. Unfortunately, the obsession with increasing volume has historically been a pretty good predictor that mistakes will be made.
The industry needs to return to its roots and underwrite loans in a safe and sound manner. It made sense to give someone coming out of bankruptcy a loan that didn't exceed 60% of the value of his home. But that 60% has given way to 65%, which has now given way to 70% in many cases.
My point is simply that the feeding frenzy of new entrants into subprime will one day exact its toll. This is clearly an asset class in which one should be the tortoise rather than the hare.
Owners and directors should stop emphasizing volume-at-any-cost. There are a lot of good production people out there, and production will take care of itself. It may come in a bit slower than you hope, but accessing the loans is not the only issue. Getting paid back is the real issue.
Let's not forget that these are loans to people with poor credit. You cannot be careful enough.
To all directors and senior managers of mortgage lenders involved in subprime, I would urge a large dose of caution. Listen to your production people when they tell you your programs are not competitive. Hear them out when they tell you that you need to raise your loan-to-value limits to match the competition.
And then don't be so shy about using the most important word a subprime lender can use. It's a short word, with only two letters. The word is "no."
The dangerous loan-to-value bracket creep we are seeing will eventually lead to a day of reckoning. If your competitor is doing something stupid, there is no need to emulate his stupidity. If you set your guidelines in a prudent manner, you should stick to them. Consistent adherence to well- written guidelines is your real protection.
The margins in subprime mortgage lending are great, and there are still large profits to be earned. I would simply urge that everyone slow down, take a deep breath, and ignore the urge to build volume at ever-increasing rates. Those lenders that aren't in such a hurry may not be the fastest in the race, but they will at least be around for the finish.
