The seeds of turmoil, IBM's Tom Watson once warned, are sown in good times. We would do well to heed his advice. Neglecting nascent problems could be our undoing whenever the inevitable economic downturn finally strikes.
Despite last summer's liquidity crisis and a wave of consolidation, our industry has a lot going for it.
Larger companies are poised to gain valuable market share by acquiring small and midsize players- at bargain basement prices that will persist for the foreseeable future. Meanwhile, conditions are ideal for some small and midsize companies to aggressively court stronger partners, not only for additional financial strength, but also to gain more direct access to the capital markets.
Perhaps most important, our business continues to nurture an entrepreneurial spirit.
However, our enduring strength is not something to take for granted. To the contrary, it needs to be zealously protected, for as a new century unfolds, nonprime mortgage companies face a dual threat: first, a threat from the political world in the form of tighter regulation; and second, a potentially more dangerous threat from within our ranks - lax credit underwriting.
At first blush, the cry for "predatory-lending reform" coming from the lips of consumer advocates and a few ambitious office seekers sounds like a cause that everyone should rally around. Who wouldn't oppose predatory lending?
In truth, this charge is the classic straw man, a gross misperception that those of us in this business are all too familiar with: Lenders target low-income and/or minority consumers and drive them into the nonprime market so they can charge a higher rate and pocket vast and "obscene" profits.
Twenty years ago, many of the complaints about predatory lending would have been valid. But they are not valid today, save for a few exceptions.
The reality is that the vast majority of nonprime mortgage lenders in the past 10 years have made credit and capital available to people who once were unable to get credit at all - at very, very reasonable rates. Predominantly good companies now are providing much-needed service and dramatically expanding a previously neglected market segment. It is an achievement to celebrate.
Even so, we dare not ignore the threat that predatory-lending reform legislation represents.
Most of the proposals now wending their ways through state legislatures target all lenders, not just the few who may still practice predatory lending. Worse, if these measures become law, they undoubtedly will restrict availability of desperately needed credit to the very individuals the legislation purports to protect - and reverse a generation's worth of progress.
To see how far we've come and why our progress deserves protection, recall what this business was like when I entered it 20 years ago. Essentially, there were two alternatives: Banks, savings and loans, and a few mortgage bankers lent funds to A-quality borrowers; those who didn't qualify were at the mercy of consumer finance companies whose rates could be as much as 10 percentage points higher.
Today, the natural and spirited competition that has developed has squashed the gap between a prime loan and nonprime loan to somewhere between an average of 200 and 300 basis points, and financial markets are far friendlier to millions of people. In the process, we also have created any number of tremendously innovative products.
We have witnessed a stunning shift, one that offers proof that the marketplace, laissez-faire economics, old-fashioned Yankee ingenuity, and entrepreneurial spirit still work and, in fact, are far more effective than government involvement could ever hope to be.
Sadly, too many consumer advocates refuse to recognize this, just as they refuse to understand the consequences of what they advocate.
To see the full impact of their proposals, watch what happens in North Carolina, where a law that takes full effect in July now is being phased in. It tightens loan requirements to the point that it will be all but impossible for nonprime lenders to do business there. Effectively, it redefines high-cost loans, prohibits charging a prepayment penalty, and eliminates the ability to recoup fees and loan origination expenses.
Unfortunately, North Carolina is not a solitary example. Consumer advocates, in fact, hold it up as a model of reform. Sure enough, similar measures are being considered in other states, including New York.
If these statutes become commonplace, good lenders who offer good products will be forced out of states where these statutes are enforced. Indeed, our company may be forced to cease offering loans in North Carolina, a state we entered less than a year ago. Mortgage brokers, who still originate 60 percent of the business, will be affected as well.
The real tragedy, though, will be the effect on consumers. They are liable to be forced back to the old hard-money sources of yesteryear: higher-rate personal and consumer loans, title loans, pawnshop loans - even loan sharking. After we've made such tremendous strides and built a very legitimate business, it would be a shame indeed.
By now you should detect a call to action. The National Home Equity Mortgage Association is taking a lead role in support of improving current regulations. The association believes in a package of targeted reforms that better protects consumers from unscrupulous practices, provides them with information to make smart borrowing decisions, and preserves their right to tap into their home equity.
It supports a law that provides substantive legal protections against fraud, deception, and unfair practices such as flipping and equity stripping and that offers consumer protection laws to all parties involved in a transaction. The association believes that it is in the best interest of the borrower and the lender to promote market competition and to prevent regulation that would leave consumers without sources of fairly priced credit and eliminate an entire segment of the home equity lender's market.
There is a bigger challenge in the near term, but it has nothing to do with politics. The same red-hot competition that has brought benefits to consumers has left too many competitors indifferent about credit quality.
Perhaps it is understandable. As companies vie for market share, the temptation to increase the amount of risk they're willing to assume is strong indeed. Unfortunately, they have succumbed to this pressure without allowing for risk-based pricing. And, because this all has happened in what has been a stable, friendly economy, our industry has been lulled into a false sense of security, while our zeal for quality lending practices has cooled.
For example, what we routinely would have labeled a C-quality loan six or seven years ago - and thus limited to funds equal to no more than 75% to 80% of the value of the house - today is likely to be classified as a B-plus to A-minus quality loan and be eligible for upwards of 90% to 95% LTV. At the same time, we've also allowed ourselves to live on ever-narrowing margins that don't begin to justify these risks.
Somewhere down this road we're now traveling at 100 mph is a brick wall - an economic downturn. We would do well to slow down and reassess our practices before we hit that wall. Those who ignore this inevitable event do so at their own peril.
At some point, the risks we've taken in lending - accepting higher and higher LTVs and low profit margins - are going to come home to roost. Capital markets have tightened before. They can tighten again. Only this time, the losses could be devastating.
I am all for competition, but this industry needs to realize that short-term aggressiveness is going to wreak havoc in the long term if we don't remember that we are in a risk-based lending business.
Adopting this long-term view may take a courageous stand, because changing today would put most companies at a decided competitive disadvantage. Experienced executives know full well that sound underwriting practices must resurface and risk management must once again outweigh the desire for market share.
It's time to take that step. Yes, business has changed, but the principles of lending have not. Risk remains risk. Just as Mr. Watson's advice remains valid.