Lenders in low-quality credit warn that loans pose servicing challenge.

CHICAGO -- Lenders are taking a closer look at borrowers who don't meet conventional credit standards as a source of profitable business, but those already out in the field advise: Proceed with caution.

The loans are widely known as B and C paper, and some lenders even get down to D-quality credit. Such loans pre-sent an added servicing challenge to lenders.

"The servicing of these loans is quite different," warned Mark S. Sussman, director of portfolio services for Anivan Portfolio Ltd., Carle Place, N.Y.

Interest in alternative types of lending has soared in recent months with the sudden decline in origination volume because of rising rates.

Speaking at the national real estate lending conference of the Savings and Community Bankers of America, Mr. Sussman, advised lenders that B and C loans were a different animal than they are used to dealing with.

"You must stay on top of it or else it gets completely out of hand," Mr. Sussman explained. "It's like an elephant that makes you a lot of money, but you want to make sure you don't step in something."

Higher Delinquency Rates

As can be expected, delinquency rates are also higher. Delinquencies can range from 2.5% for A-minus paper to 10% or more for D-rated paper, the lowest category.

The loans also demand additional outlays of resources, including beefing up the collections staff, which he said is essential to stop any patterns of delinquency before they develop.

"You can expect to spend twice as much servicing B to D loans as you would normal products," said Mr. Sussman.

While the costs may seem outlandish to some, the rewards can seem almost irresistible

Gerard E. McConnell, an account executive with ContiMortgage in Hotsham, Pa. said the loans pay for themselves because of the high interest rates lenders can charge.

As an added cushion of protection, B and C loans typically have a lower loan-to-value ratio, which lenders can use to hedge the risk of foreclosure. Mr. McConnell said that if done right, the alphabet loans can be a strong profit center.

Mr. Sussman agrees.

"You can make 300 to 400 basis points on a loan and that's just if you sell it off," Mr. Sussman said. "They have the opportunity to make fee income from the servicing."

Strong Appeal

For portfolio lenders, the appeal is also strong. "At 4% cost of funds and an interest rate of 14%, that's 10% on the books," said Mr. Sussman. He added that the loans stay on the books for only four to five years.

Charging some consumers higher interest rates may bring to light questions of fair-lending practices. Lenders have to be ready to defend their approach by laying it on the line with borrowers and regulators.

"You have to lay the groundwork out up front and say 'Look, this is why you're not getting this rate - look at your credit rating,' and that's when they'll accept that 11% or 12%," said Mr. Sussman.

Lenders have to cast themselves in the role of the provider, said Mr. Sussman, who views this type of lending as a service to borrowers who normally would not be able to acquire lines of credit elsewhere.

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