Tennessee River near Chattanooga
Subprime lending refers to the extension of credit to persons who are considered to be higher-risk borrowers. In lending parlance, their credit ratings are “B” or “C” rather than “A” or “A-”. Lenders typically price subprime loans to borrowers at rates of interest (sometimes an additional 5% or more) and points and fees (sometimes 10% or more) higher than conventional loans. The subprime mortgage industry has flourished because it has been profitable, demand from borrowers has increased, and secondary market opportunities are growing.
● The Size of the Industry. In recent years, subprime mortgage lending has grown dramatically. The number of subprime home equity loans has grown from 66,000 in 1993 to 658,000 in 2000, a tenfold increase. Over this same period, the number of subprime loans to purchase homes increased nineteen fold, from 16,000 to more than 306,000. Gramlich, below. It has become larger still in recent years.
● The Role of Mortgage Brokers. They handle about half of all home mortgage loans. In theory, they operate as the agents of borrowers with corresponding fiduciary obligations. In practice, they often have arrangements with lenders that contain incentives to steer borrowers to the lenders that pay brokers the most, rather than the lenders that provide the most favorable terms for borrowers.
● The Secondary Market. Some high-rate mortgage lenders have historically operated by assigning their loans or installment contracts to other lenders such as finance companies or banks. The 1980’s added a new wrinkle – bundling mortgage loans into large portfolios and selling them in the secondary mortgage market.
This technique enabled mortgage companies, mobile home sellers, home improvement contractors, and other lenders to operate more profitably. They could obtain a line of credit from a bank, originate loans with high front-end fees, sell them in the secondary market, and start all over again.
● Securitization. Since 1994, through a device called securitization that has long been available for conventional mortgage loans, Wall Street investment banks have played an increasingly important role in raising funds for subprime loans. Securitization works like this. Loans are pooled and assigned to a trustee that supervises the servicer of the loans and distributes the monthly return to the owners of the interests in the pool. Pools of loans are sometimes insured, and they are rated by bond-rating agencies. An investment banking firm invites investors to buy ownership interests that pay interest over a specified term. Interest payments are often guaranteed by bond insurance companies. The risk of loss to investors is partially reduced by insurance and by recourse agreements between the trustee and the lenders.
● Entry by Conventional Lenders into the Subprime Market. At the same time that subprime loans have become a significant and growing part of the home equity market, the composition of companies involved in the subprime market is evolving. One of the dramatic changes in this market has been the growth in subprime mortgage lending by large “prime” or “conventional” lenders. For example, the nation’s largest financial institution, Citigroup, acquired Associates. The second largest, J.P. Morgan Chase, purchased the loan portfolio of Advanta.
●Targeting Elderly, Low-Income, and Minority Borrowers. Elderly homeowners, in particular, are frequent targets of some subprime home equity lenders, because they often have substantial equity in their homes, yet have fixed or declining incomes.
Subprime loans are three times more likely in low-income neighborhoods than in high-income neighborhoods. See HUD/Treasury Report, supra at 45.
In predominately black neighborhoods, subprime lending accounted for 51% of refinanced loans in 1998 -- compared with only 9% in predominately white areas. Borrowers in black neighborhoods are five times more likely to refinance in the subprime market than borrowers in white neighborhoods. Id.
● The Risk of Loss. By several techniques, lenders make adjustments for the increased risk associated with subprime lending, reducing it substantially and making this type of lending profitable.
Late fees – usually 5% of the payment then due -- compensate for default in monthly mortgage payments. Keeping the ratio of loan-to-value below 80%, and purchasing private mortgage insurance when it is not, helps to keep foreclosure losses, on average, below 1% of loan balances per year. See Renuart, below at 27. Prepayment penalties (found in some 70% of subprime loans, Id.) enable lenders to prevent losses from early payment of principal balances on loans that contain high front-end costs that have not been fully amortized over the expected lives of the loans.
● Which Companies are Subprime Lenders? Here are some of the larger ones:
● Which Companies are Subprime Loan Servicers? These are a few of the larger ones:
Most of the analysis above is based upon the Prepared Statement of the Federal Trade Commission before the House Committee on Banking and Financial Services on Predatory Lending Practices in the Subprime Industry (Federal Trade Commission, May 24, 2000), http://www.ftc.gov/os/2000/05/predatorytestimony.htm, and Elizabeth Renuart, prin. ed., Stop Predatory Lending: A Guide for Legal Advocates, Boston: National Consumer Law Center, Inc., 2002. See also the Prepared Statement of the Federal Trade Commission before the Board of Governors of the Federal Reserve System on Predatory Lending Practices in the Home-Equity Lending Market (FTC, September 7, 2000). http://www.ftc.gov/os/2000/09/predatorylending.htm
See further the Remarks by Federal Reserve Board Governor Edward M. Gramlich at the Housing Bureau for Seniors Conference, Ann Arbor, Michigan, January 18, 2002). http://www.federalreserve.gov/boarddocs/speeches/2002/20020118/default.htm. Finally, see Curbing Predatory Home Mortgage Lending: A Joint Report, United States Department of the Treasury and United States Department of Housing and Urban Development, June 2000.