Rick Pollack · Subprime is not necessarily subprime

October 30th, 2008

Continuing on with the discussion of the financial crisis…

One item that seems to be either confusing or misunderstood is that there is no “subprime” loan. Borrowers are assessed based on credit score, credit history, down payment, income level and verifiability, and debt-to-income and then graded the same way a test was graded in high-school (or the way it used to be graded in high-school) – A, A-, B, C, D. An ‘A’ grade is considered to be investment caliber and qualifies for prime rates; borrower grades below A (A- to D) are all considered subprime. Loan performance varies widely based on the borrower’s grade. In March 2004, a senior executive from New Century Financial Corporation (bankruptcy: 4/2/07) met with members of congress to explain subprime (or as he referred to it non-prime) lending:

“Today, the non-prime market has grown significantly into a highly competitive market. In 1994, there were $34 billion in non-prime mortgage originations, representing about 5% of the overall mortgage origination market. Last year, originations grew to roughly $325 billion, which represented 10.5% of all mortgage originations.
Much of our industry’s dramatic growth has been due to the securitization of non-prime mortgages. The industry depends on the liquidity generated by the secondary market in order to bring affordable mortgage credit from Wall Street to Main Street. In 1994, $11 billion of non-prime mortgage loans were securitized. By 2003, this had increased to around $215 billion, which represented 66% of the entire non-prime market. Securitization has greatly increased the availability of mortgage capital and has helped lower borrowers’ cost.
In particular, the growth of the non-prime mortgage market since the early 1990’s has dramatically transformed the national mortgage market by providing access to credit for millions of Americans who historically have been unable to qualify for credit under so-called ‘prime’ mortgage underwriting standards.” – Subprime Lending: Defining the Market and Its Customers

Scroll down to page 39 of the report – New Century Delinquency and Foreclosure Rates for 2001, 2002 and 2003 – and take a look at the delinquency and foreclosure rates. Keeping in mind this report was presented in March 2004, the 90+ day delinquency rate for 2001 was 19.25% with 6.25% already in foreclosure. As bad as that sound, it gets worse:

Here are the 2001 90+ day delinquency rates by FICO and Delinquency rate:

FICO   Delinquency

700+         5.26%
660-699   4.31%
620-659   10.19%
580-619   19.32%
540-579   22.02%
500-539   26.82%
<500        34.36%

This chart was included in testimony and presented in a joint session to the Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Housing and Community Opportunity. Serious delinquency (90+ days) rates for prime, conforming loans have historically been under 1%. Within three years of issue, 10% – 35% of the New Century loans were already delinquent with more than 6% in foreclosure. (Though I previously said anything below grade A credit is considered subprime, a FICO score of 620 is generally considered the line between good and bad credit. I have also seen definitions of subprime that consider only scores below 620 to be subprime. What is a good credit score?)

GSE Subprime Volume

The GSEs saw what was happening in the subprime market and believed given their decades of lending experience, their automated underwriting systems, and their established structure and policies, they could bring efficiency to the market – lower closing costs and reduce lending rates – and establish standardized subprime products. (I will discuss the GSE role in the crisis in my next post)

Until about 2000, the GSEs dealt almost entirely with prime loans that ‘conformed’ to their stringent underwriting guidelines. “According to Inside B and C Lending, Freddie Mac purchased $18.6 billion of subprime (mostly Alt A and A-) loans on a flow basis in 2000. In addition, Freddie Mac purchased another $7.7 billion of subprime loans through structured transactions. Fannie Mae’s participation in the subprime market was much smaller: it only purchased about $600 million of subprime loans on a flow basis.” – Subprime Markets, the Role of GSEs, and Risk-Based Pricing (2002) (HUD)

“Alt A mortgages, typically originated to borrowers who cannot document all of the underwriting information in their application. Alt A loans can either be used to purchase a home or to refinance an existing mortgage. These borrowers have FICO scores similar to those in the prime market” – HUD

“Fitch, Inc. reports that subprime mortgages, originated to credit impaired borrowers that receive A- and B ratings, typically are issued to borrowers with credit scores that range between the high 500s and low 600s. This is in marked contrast to the credit profiles of Alt A borrowers.” – HUD

As of June 30, 2008, the Fannie Mae’s Single-Family Book of Business held $2.8 trillion of mortgages and mortgage backed securities. The bulk of Fannie Mae’s and Freddie Mac’s Book of Business are prime, grade A, conforming loans. The weighted average FICO score was 722, the weighted average loan-to-value (homeowner equity) was 72%. Also contained within their Single-Family Book of Business are $340 billion Alt-A and $48.3 billion subprime (A-) mortgages and mortgaged backed securities. The total serious delinquency rate for their Single-Family loans, as of July 2008, was 1.45%; the delinquency rate for their higher quality loans is 0.8% and the delinquency rate for their recent, lower quality investments is almost 4%. The overall delinquency rate is climbing at a rate of 0.05% – 0.1% per month.

Fannie Mae Second Quarter 2008 Results includes detailed characteristics of the loans in the portfolio.

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