Loan officers switching from A paper to subprime mortgage lending often have difficulty. Their world has looked on B and C lenders as unethical gougers taking advantage of uneducated and ill-informed borrowers.
Nothing could be further from the truth. Prime quality loan originators need to be educated about the social good in which they will be engaged as subprime lenders. Unfortunately, experience shows that many will not be able to make the mental shift.
Is charging six points and 11% somehow improper? Is there anything inherently wrong about such pricing?
Markets are efficient in pricing risk, and the subprime borrower is subject to such pricing solely because he has bad credit. Had he kept his credit pristine, he could and should get the market rate for A paper.
The borrower paying eight points and 11% might have been late on his mortgage payments three or four times in the last year; he might have had five or six late payments on revolving credit; his debt-to-income ratio might be high.
The typical subprime borrower is drowning in debt. In our experience, it is not atypical to find a borrower with a $40,000 mortgage at 9% and $60,000 in credit card debt at an average of 21%. The monthly costs for servicing this borrower's debt are $321 on his mortgage and $1,050 on his credit cards - $1,371.
Assume that the borrower is granted a new loan of $110,000. There is $40,000 to pay off his mortgage, $60,000 to pay off his credit cards, $8,000 for the eight points, and $2,000 in title and escrow charges, along with other miscellaneous closing costs.
At 11%, his new mortgage payment is $1,047. He has reduced his total debt service by $324 a month.
For many families, a monthly saving of $324 makes a very dramatic change in lifestyle. They have replaced interest-only credit cards with a fully amortizing mortgage. In many cases, the credit card debt is replaced with mortgage debt that is tax-deductible.
Putting the above borrower into a new 11% loan is like throwing a life raft to a drowning man. Yet many lending officers still see the high rate and high points as somehow unethical.
These officers should be asked to analyze a great many of the loans their bank made in the 1992-93 refinance mania. During that time, borrowers were refinanced multiple times, each time lowering their rate by as little as an eighth of a point.
With the advent of no-points loans, loan officers could refinance a homeowner three or more times during the year, saving the borrower maybe $25 a month each time, yet collecting two or three points on the premium pricing. The borrowers' benefit was negligible, but the loan officer pocketed a large commission.
A good subprime lender should go home every night feeling that he has helped families get their finances under control.
His borrower has limited options and mountains of debt. To solve this person's problem is much more socially useful than to collect a one-point fee for selling a commodity mortgage to someone with limitless choices.
If loan officers cannot see this, they should not be expected to succeed in the world of subprime mortgage lending.
Managers should give their lending officers the opportunity to switch, but they must also recognize that in many cases they will be unable to change the lenders' antisubprime mind-set.
Mr. Garrett is president of Standard Financial, a subprime lender based in Berkeley, Calif.