Will 2013 Bring the Return of the Subprime Mortgage?

Fear, regulatory uncertainty, market instability and a lack of consumer confidence has kept the reemergence of these products at bay.  Make no mistake though; the money for these products is there.  Reemerging market stability has helped to abate the fears of some mortgage investors on the secondary market.  Consumer confidence has not recovered but it is up.  The big issue has been regulatory clarity.  Two significant events are unfolding that are likely to bring that to an end.

The first is the move by the FDIC to provide the new definition of subprime mortgages.  The first thing they did was rename subprime loans as “Higher Risk Consumer Loans”  LOL!  Yeah, . . . that’s going to stick.  These higher risk assets are defined as the sum of construction and land development loans, high risk commercial/industrial loans, leveraged loans, subprime loans and non-traditional mortgage loans.  They will be defined by Probability of Default or PD.  The new subprime, or should I say Higher Risk Consumer Loans (tee hee hee)  will be loans that have a probability of default being higher than 20% over a two year period (default being 90+ days late, bankruptcy, charged off, gone to collection or worse).  Why would banks want to make loans like this?  Because believe it or not, they’re profitable!

This FDIC proposed initiative will go into effect this October.  Perhaps the most onerous part of this rule will be the reporting component but it won’t take long before the large banks affected have it all figured out.  When they do and their balance sheets support it, it’s likely they’ll look to expanding credit product offerings.  That is, . . . after the second part of regulatory clarity is in place.

The second major regulatory clarity will come before the end of the year when the Consumer Finance Protection Bureau defines a Qualified Residential Mortgage or QM.  The qualified residential mortgage provision, from the Dodd-Frank law, forces banks that issue mortgage-backed securities to retain at least 5% of the value of the portfolio on their own books.  In this, the CFPB will and is contemplating thresholds on elements of loans such as Loan to Value, Debt to Income Ratios and other loan feature used to evaluate risk.  I’m a CFPB fan but this is pretty creepy to watch happen because the ramifications of mistakes on the housing industry will be mind-blowing should any be made.  One thing is clear, the chips will have fallen and large institutions will know what type of loans they can offer without constraining their cash reserves.  More importantly perhaps, when their balance sheets are flush (and some already are), it will let them know how to evaluate mortgage securitizations that they would have to hold back cash reserves on but might want to make anyway.  Why would they want to make loans like that?  Because it’s profitable!

This could be a good thing.  Let’s say a buyer had a short sale but otherwise had a fantastic borrower profile.   Great cash reserves, strong income, low debt and a 25 percent down payment.  Why wouldn’t a lender give a loan to that person after one year from the short sale closing knowing that they might qualify to refinance into a Fannie Mae loan under the extenuating circumstances rule after one year or refinance into a FHA loan after 2 years.  In the meantime, that lender makes great fees on giving the loan and an excellent spread on the rate they give on the loan.  Oh and let’s not forget that getting strong buyers into the housing market is a fantastic thing too.  This can be a win-win.  Sometimes, greed is good.

For anyone who doesn’t think subprime will come back, they need only look at how cyclically history has repeated itself.  Late 80’s, . . savings and loan crisis.  Subprime came back.  Late 90’s, . . subprime liquidity crisis.  Subprime came back.  Late 2000’s; well, I think we all remember that.  It seems to come around every 10 years in the mortgage business.  And once again, subprime will come back again because its profitability is just too tempting.  With these two regulatory hurdles out of the way, look to mid-2013 for some strange mortgage products to show up.  With these two rules in place keeping things in check, I’m all for it.