Investors are looking for higher yields, and nonconforming mortgages are increasingly filling the bill.
"Not all homeowners have the credit history to permit a conventional refinancing, even though they may have substantial equity in their homes," said Robert C. Mercer Jr., president of American Financial Corporation of Tampa.
Speaking at a recent New York seminar on alternative opportunities in mortgage originations, Mr. Mercer said home equity loans to people with lower credit quality was attractive to investors because of premium yields. But he warned that "this is a profitable market segment [that] must be approached with caution by inexperienced lenders."
Lenders who make such nonconforming loans generally stretch in the area of credit history and debt to income ratios (see accompanying table).
The lower loan-to-value ratios and higher interest rates offset the higher risk involved, Mr. Mercer explained.
"At AFC, our focus is on A through D loans [the top four quality grades], although our product mix extends to F loans," he said.
"Each lender establishes its own target market segment. In every case, however, the key is balancing risk and reward; a lender needs criteria that risk-rank loans."
He added that the process was highly judgmental and required experienced underwriters. "Underwriting nonconforming loans is completely different from underwriting conforming loans and is more like consumer lending," he said.
Mr. Mercer pointed out that appraisals were crucial to a successful loan strategy and must reflect the true value of the home. "Nonconforming lenders must carefully select the appraisers they will use, and must develop methods of tracking the quality of appraisals over time," he said.
An aggressive collection process is also important, he added. "Many nonconforming lenders begin active collection efforts at five days past due; at AFC, we begin at one day," he said.
While it is not hesitant to begin foreclosure proceedings when the collection process stops working, Pittsburgh-based American Financial tries to find ways to refinance or rehabilitate the loan right up to the date of the sale, Mr. Mercer said.
Another speaker, Adrian Katz, a managing director at Prudential Securities, New York, pointed out that there was an active market for home equity loans on Wall Street and that Prudential bought, sold, and traded loans as well as securities backed by home equity loans.
He said that from an investor standpoint, there was no additional risk because of credit enhancement that brought the securities up to triple-A.
He also said Prudential was ready to buy agricultural loans and to securitize some commercial mortgages.Relaxing the Standards How American financialcompensation for lowercredit quality Max. Max.Credit loan/ debt Currentquality value ratio rate Good 80% 50% 8.50% Fair 80 50 9.50 Poor 75 50 11.25 Bad 65 50 14.00 Source: American Financial