The rapid rise of B and C home loans is more than just a flash in the pan. It involves a broad redefinition of credit standards that is sure to have a lasting impact on the mortgage business.
Technology appears to be a major driving force behind the rapid rise of subprime lending. Elaborate computer models and large data bases of lending experience have fostered wider use of credit scoring, making subprime lending easier and safer for both lenders and investors.
So lenders, squeezed by thin profits on conventional loans, have been far more willing - many have been downright eager - to venture into this still-lucrative field. And the availability of underwriting technology has encouraged them.
Credit-rating agencies also have embraced credit-scoring technology to rate securities backed by B and C mortgages, bolstering investor confidence and stimulating market enthusiasm.
The impact of these developments has been far-reaching. Freddie Mac, for example, discovered in performing the underwriting on loans submitted as subprime (which it can't buy), that about a third of them qualified as prime loans (which it can buy). By contrast, relatively few loans sent in by lenders as B and C became rejects under Freddie's underwriting scheme.
One reason for the higher quality found by Freddie is that scoring models don't use single factors to disqualify borrowers from prime status, as the manual, rule-based systems do. Instead, they examine offsetting factors, singly and in combination.
Further, Standard & Poor's has come up with seven rating categories for bonds backed by credit-scored loans. The top three all qualify as prime - meaning that there are definable degrees of quality even in A paper.
These gradings should facilitate wider, and more accurate, use of risk-based pricing by lenders. At least one former conventional lender has already switched to B and C (see article, p. 12A) and is using the S&P gradings to price its loans.
That lender says its credit-scored B and C loans are performing better than many of its A loans. A possible reason: Credit scoring relies more on data from independent sources than on information in the application, which may contain misstatements.
Better pricing eventually will mean lower prices for consumers, which could greatly expand the subprime market.
Many top subprime and home equity lenders have developed highly effective telemarketing capabilities, a very low-cost way to originate loans. Effective targeting of customers through credit scoring contributes to the efficiency of telephone sales.
Geoffrey Oliver, a partner with KPMG Peat Marwick in Washington, says lenders can cut costs by more than 25% through telemarketing. But profit-starved companies are less likely to be willing to make the technology investment than others.
The B and C market is showing lenders that good profits can be made in the mortgage business - not just through high margins, but also through technologically driven efficiencies.
