The subprime mortgage market seems to be disaster-proof.
Even in the wake of failures of several subprime lenders, banking companies of all sizes have been ambitiously expanding into subprime credits, a market that until just a few years ago they sniffed at as too risky.
"They are being challenged by nonbanks for their business and they are figuring out ways to compete more effectively for, let's say, less-creditworthy customers," said James A. Verbrugge, chairman of the department of banking and finance at the University of Georgia.
Mr. Verbrugge chooses his terminology gingerly because he despises the term "subprime." He wholeheartedly endorses this relatively new activity.
Indeed, the subprime market appears to have been restored to respectability. "Referring to the middle and lower middle market as subprime is misleading and even derogatory," said Mr. Verbrugge, co-author of a major study on subprime home equity lending. "They are as much a part of the mainstream as the upper middle market."
Two big steps toward respectability for subprime lending came last year when Charlotte, N.C.-based First Union Corp. bought Money Store for $2.1 billion and Conseco Inc., a Carmel, Ind.-based insurance company, acquired Green Tree Financial Corp. for $6 billion.
Moreover, other top-tier banks have been quietly active in the field for a number of years, including Columbus, Ohio-based Bank One Corp. and Cleveland- based KeyCorp. A KeyCorp spokesman said his company, like Mr. Verbrugge, eschews the term "subprime."
Most banking observers applaud subprime lending but some concerns are being expressed about whether the credits are priced appropriately to offset a likely high level of defaults during the next recession, whenever that may occur.
Mark J. Riedy, head of the new Real Estate Institute at the University of San Diego, said he did not think companies were pricing subprime loans correctly.
But only time will tell if he is right, he conceded. "We haven't had a serious recession since B and C borrowers got into the market," said Mr. Riedy, who is also a professor of finance. "It's not been put to the test."
But Philip Jackson, a Federal Reserve governor from 1975 to 1978 and a career mortgage banker, strongly disagreed with Mr. Riedy's position. He said banks were pricing their subprime credits correctly because they have learned how to do so from two other categories of loans.
Mr. Jackson cites credit card lending and loans that banks have been making to B and C borrowers to meet the provisions of the Community Reinvestment Act of 1977.
"They have handled their CRA requirements much better than they had anticipated," said Mr. Jackson, who retired in 1989 as vice chairman of Birmingham, Ala.-based Compass Bancshares Inc., where he oversaw residential mortgage lending at the banking company.
Just as is the case with pricing credit card loans, subprime loans are being priced in anticipation of a higher level of defaults and foreclosures than with A mortgages, Mr. Jackson said. Therefore, he added, subprime portfolios on an overall basis are profitable.
"Banks are willing to accept reasonable levels of losses with certain types of risks because we're interested in the net and not the gross," added Mr. Jackson, who retired in May as a banking professor at Birmingham-Southern College.
Mr. Verbrugge agreed with Mr. Jackson, saying he assumed banks were acting prudently by following correct capital-allocation policies.
"You should allocate enough capital to actually reflect the risk underlying that activity," he said. "That capital allocation may be greater than required by the regulators to cover high, unexpected losses."
Mr. Verbrugge also said that he felt that the content of bank portfolios was sufficiently varied. "If one sector softens, there should be enough diversification so that one hiccup in one activity is not a hiccup for the whole bank," he said.
Key to making subprime lending a profit center is that borrowers must be judged by underwriters who have a mindset different than their A loan counterparts, said John C. Weicher, a senior fellow at the Hudson Institute, a conservative think tank.
A-loan underwriters will simply disqualify B and C credits out of hand, said Mr. Weicher, who wrote the book "The Home Equity Lending Industry: Refinancing Mortgages for Borrowers with Impaired Credit," which was published last year.
Whether B and C credits are a good risk or not for mainstream banks "depends on whether they are ready to change the way they underwrite them," Mr. Weicher said.
He said the underwriting process for B and C borrowers must be far more hands-on and judgmental. "You can't distinguish them from an A on demographic or economic criteria," he said. "You have to understand their history and make some sense out of it."
Loan officers who handle A credits "don't know what to make of it," Mr. Weicher said.
An important safeguard in the process is that the executive who reviews originations must be thoroughly familiar with the subprime market, as well as the bias of the loan officers toward their customers, Mr. Weicher said.
"The incentive for the originator is to err on the side of a little too much risk," he said. "The next guy up should be paid to be careful, to know if a loan needs to be redone or if it's a no-go."
While it is acceptable to have B and C originators on a bank's premises, they should not be the same people who work on A credits, said Mr. Weicher. Mr. Verbrugge concurs, adding that if a borrower seeks an A loan but fails to qualify, the loan officer should send the borrower to a subprime originator, who should be operating in the same building.
"It doesn't make sense to send someone down the street, or 20 miles away," he said.
Mr. Riedy, however, cautions that a subprime borrower at one bank may be an A customer at another. "We are finding that B credits are becoming A quality," he said. That is because the original underwriting was faulty, Mr. Riedy said.
In addition, he added, competition between lenders is so ferocious that some of them are willing to take a second look at a borrower previously deemed unqualified for an A loan, he added.
"There is so much money in the mortgage business chasing not enough borrowers," he said. "We've stretched where to make loans."
Despite Mr. Riedy's fear that subprime loans are being underpriced, he concedes that originators of these loans have become much better underwriters. "They understand better the risks of delinquency and loss," he said.
He also agrees that a different mindset is required in judging B and C credits than for A loans. That is why most banking companies entering the field are doing so through acquisitions, he added.
"The risks they're acquiring by buying a subprime lender need a different group of talent than would be found in a bank," he said. "They couldn't do it."
In addition, lenders are getting better by learning from their current B and C portfolios' behavior. "You're always adding into the system last month's experience and that makes it a better underwriting process," Mr. Riedy said.
He also expressed some second thoughts on whether the next recession might cause the subprime market in general to start hemorrhaging. The blow would be lessened considerably if the economic downturn occurred on a rolling regional basis. In that case, lenders with national portfolios might pull through in relatively good shape, he said.
"The U.S. economy may react regionally rather than nationally," Mr. Riedy said. "So it could be that economic stress will be limited to certain regions."
