Every five years or so the sub-prime industry in the US goes through a cleansing process that is usually preceded by a boom where new entrants (and ‘A’ paper players) join the fray because the profits look great.Then something unforeseen happens and the market gets creamed, with bankruptcies soaring followed by a wave of consolidation. This happened in 1998 when the Russian debt crisis hit the bond market like a tsunami and Wall Street suddenly became risk adverse and began calling in loans. But that wasn’t the market’s only problem. In the late 1990s many sub-prime firms (particularly publicly traded ones) were abusing gain on sale accounting rules in regard to loan securitisations which allowed them to book ‘tomorrow’s profits today’. In a perfect world this is fine but certain lenders – The Money Store comes to mind – were being too optimistic on prepayment and delinquency assumptions. In time, profits that were booked had to be restated and many lenders hit the skids. I mention this history only because the US sub-prime market is at the cusp of a new cleansing process, one in which poorly managed firms that were riding the production boom will be kicked to the curb and swallowed by larger firms. Most at risk are publicly traded real estate investment trusts that specialise in sub-prime and other non-conforming credits. During a downturn lenders need to preserve cash and live off the fat of previous years’ earnings. They also live off their servicing portfolios. But REITs have to pay out most of their quarterly earnings to shareholders in the form of dividends. If the cash is going out the back door to shareholders, how can they build for the future? The sub-prime sector’s biggest problem isn’t necessarily production volumes although it soon may be. In the first quarter of 2006 sub-prime lenders funded $182bn, an 18% sequential decline from the fourth quarter, but a 7% increase from the same quarter a year earlier. The industry’s biggest problem is profit margins. Thanks to a flattening of the yield curve and fierce competition for product, profit margins have come under severe pressure. From 2001 to 2004 sub-prime lenders selling into the secondary market could receive 103 to 105 for their loans depending on credit quality, yield, and other factors (103 means that on a $100,000 mortgage the seller receives $103,000 from the buyer). What made the deal even sweeter was the steep yield curve. Remember when the overnight Federal funds rate was just 1%? That meant a sub-prime lender originating a loan at 7% (which is a great rate for a B&C customer) with a cost of funds of 2% would have a gross profit margin of 500 basis points. For firms like Ameriquest, Long Beach Mortgage, New Century, and other volume giants it was manna from heaven. In fact, it was so good that traditional prime players like Wells Fargo began chipping away at the least risky piece of the market, the A- sector. The A- niche was aided by mortgage insurance firms entering the business, insuring the credits. Things looked good in sub-prime. But then the Fed began ratcheting rates up a quarter of a point at a time, and by early 2005 profit margins began to slip. As lenders’ costs of funds increased, they had little room to manoeuvre because the market was flooded with funders, many of which refused to raise their mortgage rates, fearing loss of business. By early 2006 the profit picture showed little improvement. Sub-prime residential lenders funded a record $807bn in 2005. This was a huge milestone, but even more noteworthy was the niche’s market share. In 2005 sub-prime loans accounted for 26.5% of all residential originations in the US – a gain of 4.7 market share points from 2004. Keep in mind that in the mid-1990s sub-prime accounted for just 5% of the residential production business. So within 10 years sub-prime has grown five-fold. But there are a few caveats. Sub-prime has matured, grown and improved. It has moved into the modern age and many lenders are trawling the internet for customers instead of using the back pages of the sports section. Commercial banks are players in sub-prime in a big way. The top 10 funders – with the exception of Ameriquest – are publicly traded or owned by a publicly-traded parent. Why do they like sub-prime? Because the profit margins are decent or at least they used to be. As state and federal regulators ratchet up the pressure on lenders in regard to consumer protection and compliance originators will have to ask themselves – are sub-prime profits worth the hassle?
With just over a year to go until Home Information Packs become compulsory, 11% of estate agents still do not know what Home Information Packs are, figures have revealed.Easier2move has conducted monthly surveys tracking estate agents awareness of the HIPS and the issues surrounding them.The figure is the same as it was in April, when […]
What a fantastic first half of the year. The market remains buoyant and latest lending figures show an upward trend. And all this despite doom mongers saying it would never last.
Support is critical in the mortgage industry. Kevin Paterson’s A-Z review rates the marketing material that lenders issue to help brokers with sales and business development
Guaranteed and Genesis Home Loans have appointed Jonathan Story as head of IT development.Story will help build and implement new IT and e-commerce within the group, whilst also monitoring and analysing the market with a view to integrating both lender and insurance systems wherever possible.Story has held a number of senior roles within the finance […]
By Chris Taylor, Manager of the Neptune Japan Opportunities Fund H1 2014 Economy: after a harsh winter that slowed activity in the economy, the main event of the first half of the year has been the debate over what impact the 1 April VAT hike from five to eight per cent would have; we are […]
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