Wall Street is playing a major role in the growth of subprime lending. Investors' willingness to buy securities backed by home equity lines supplies lenders with steady capital to turn into new loans. Last year, investment banks doubled their volume by packaging and selling $27 billion of home equity loans as asset-backed and mortgage-backed securities. This year, the pace of growth will slow, but securitization volume should top last year's level, industry experts say. Prudential Securities helped build the market for subprime securities, and that commitment continues today under the guidance of managing director Len Blum. American Banker recently asked Mr. Blum to assess the industry. How is this year shaping up? Quite well. The market should see 25% or 30% of growth as more consumers recognize that home equity loans are great for debt consolidation. You're looking at a roughly 12% interest rate that's tax-deductible, compared with 18% for credit cards. What are the benefits for lenders? Securitization allows lenders to match-fund their production. When you securitize, you create a liability that has same-payment property to your assets. This helps lenders reduce their vulnerability to interest rate shifts. Securitization also provides a low cost of funds for most issuers. The transactions are off balance sheet, and because the risks are mitigated you need less capital than when you portfolio loans. Are there benefits for smaller companies to work with Wall Street? Loan securitization allows issuers who are unrated to issue securities at triple-A spreads, with credit insurance. When tapping capital, medium-size finance companies can be on a level playing field with larger players. What are pros and cons of whole loan sales? With whole loan sales you get more cash up-front. That can be a plus. But whole loans sales are generally done with servicing released, while securitization allows lenders to retain servicing if they want. Also, with securitization you don't have to sell your portfolio piecemeal. And you're not subject to kick-outs, where the investor doesn't follow through with purchase of all loans. Are home equity securities treated differently from mortgage issues? Home equity and mortgage are really two separate markets. Home equity loans are much less volatile if interest rates change; there is a lot less sensitivity in terms of prepayments. Does securitization pose any risks for lenders? Relative to portfolioing loans, securitization has much less risk. You're passing on credit and interest rate risk while increasing the velocity of your capital. Securitization also increases the value of a company by allowing it to grow faster. What about risks for investors? The traditional approach provides the securities with a surety wrap that doesn't protect from prepayment risk but does shield against credit risk. Now, more deals are being done without insurance, using a senior- subordinate structure in which a large piece receives a triple-A rating, and the rest of the pool gets a lower rating. Investors are rewarded with higher yields for taking on the more risky tranches, or pieces. And we should remember that the people buying these products are very sophisticated institutional investors who spend a lot of time assessing risk. How can lenders make more money, by using surety wraps or senior- subordinate structures? It's a toss-up; both methods have benefits. The senior-sub structure allows diversification from the widespread use of surety wraps. By using senior- sub structures, you're no longer so dependent on the industry's three surety companies. But surety companies do supply a triple-A rating that can add tremendous value. These companies have been around for a long time and are very helpful in getting deals done, especially for smaller issuers. A number of subprime auto loans have crashed this year. Couldn't the same happen to subprime mortgage securities? There's no way. Home equity loans are fundamentally more sound than other forms of lending, because you have the collateral of a house as backup. Wouldn't all borrowers suffer if there's a recession? There would be protection. There is a lot of geographical diversity in pools of home equity loans. Property values tend not to go down across the board. What's on the horizon for the subprime industry? There's going to be consolidation of the market. Some very large originators with a lot of capital will purchase smaller operations that have carved out a niche for themselves. Also, there are a lot of lenders that want to be in the subprime business.
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