Is there a safe way to do subprime?
With housing prices on the rebound and home equity lending growing again, a lot of mortgage originators are feeling tempted by subprime, but mindful, if not fearful, of the lessons from the freewheeling years before the financial crisis.
Jack Kahan, a residential mortgage specialist with Standard & Poor's, says there's a way to make loans to borrowers with riskier credit profiles without repeating the mistakes that fueled the crisis. He calls it "responsible subprime," and it does not include bad ideas like obscenely high loan-to-value ratios and little to no documentation.
So how will lenders resist from bending underwriting criteria so far this time around? Kahan posits that more dangerous loans will be prevented by documentation requirements of the new qualified mortgage rule, which holds lenders responsible for ensuring the borrower's ability to repay.
The current absence of new no-doc loans, and the tiny smattering of low-doc loans compared to what was seen in the 2005-to-2007 period, suggest that his conclusion is correct.
"It would be hard to see no- to low-doc lending standing up to QM standards," agrees Mark Fleming, chief economist at the data and analytics firm CoreLogic.
Third parties and automation will help lenders and investors verify the integrity of the documentation, creating another layer of prevention against subprime abuses, says Phil Huff, CEO of Platinum Data Solutions, an Aliso Viejo, Calif.-based firm that provides collateral valuation technology.
"There needs to be an uber-focus on quality of information," he says. "Is the person who they say they are? Is the quality worth what is being lent on it, and is the person capable of repaying the loan?"
This time around, interest in below-prime loans is likely to be focused on those that are not considered qualified mortgages but are eligible for a safe harbor from ability-to-repay liability.
"Some people are referring to that as the new subprime, which I think is at least semi-appropriate," Huff says.
Based on historical performance, borrowers that are "fairly deep in the reputational pool" in terms of credit scores should probably be limited to loans of no larger than $300,000 to $350,000, with maximum loan-to-value ratios of 65%, says Stanley Middleman, CEO of Freedom Mortgage, a QM lender in Mount Laurel, N.J.
Ultimately what will define the bounds of "responsible subprime" will be originators' risk-based pricing models, regulation and the dictates of the government-sponsored entities that control the secondary market.
"The industry is going to behave in a fashion that limits its liability," says Middleman. "If the return supports the risk, lenders will make the loan, but we've been regulated into a fairly tight box that is limited by returns that have been somewhat limited as well."