by Dan Krell
The adage that we are doomed to repeat history unless we learn from it is once again demonstrated. The recent news that the subprime mortgage industry is in trouble should not be a big surprise. The fact that subprime lenders are in trouble is the consequence for an industry whose foundation is high risk.
If you are unaware of the subprime mortgage industry, here is a rudimentary primer. Subprime lenders provide mortgages to borrowers who would not otherwise qualify for a standard Fannie Mae/ Freddie Mac loan. Most often, these borrowers have credit challenges; however, some have good credit but do not meet the Fannie/Freddie income, asset, and/or employment guidelines.
The subprime lenders’ underwriting guidelines dictated by investors who ultimately buy the mortgages on a secondary market (usually Wall Street). The attraction to investors is that they receive a high yield based on the risk. Generally, subprime underwriting guidelines become lenient when the market is favorable for these loans.
Up until about a year ago, the subprime mortgage industry exploded because the risk was countered by a safety net that was the record sellers’ market. Many subprime borrowers who fell behind in mortgage payments found themselves able to sell their home before foreclosure, pay off their mortgage, and make a little money in the deal.
Since the market has slowed, many subprime borrowers cannot sell to avoid foreclosure. This has impacted subprime lenders by the loss of revenue. Subprime investors have forced lenders to tighten their subprime underwriting guidelines to meet new requirements and lessen their risk.
The subprime mortgage industry has a cyclic history of loosening and tightening of underwriting guidelines. The last time the subprime industry was in a crisis was in the latter part of the 1990’s when mortgage fraud and illegal flipping schemes were widespread and took advantage of the loose subprime underwriting guidelines of the time.
At that time, subprime lenders lost millions on blatant fraud and real estate schemes. Some loan officers and mortgage companies found it easy to perpetrate fraud on loan files so as to have the loans approved. Additionally, schemes using tactics such as straw buyers or fraudulent appraisals were devised either to defraud lenders or take advantage of home buyers, or both.
In response, “due diligence” became the hot buzz word. Subprime lenders were forced to tighten their underwriting guidelines and institute a number of quality assurance checks, both prior to loan approval and post settlement.
Although we may not feel compassion for the lenders and investors of subprime mortgages, the unfortunate casualty is the consumer. The last few years found an explosion of minority home ownership that is unprecedented. Unfortunately, as reported in a front page article in the Washington Post (March 26, 2007), many of those affected by the perfect storm of a declining real estate market and high risk lending are recent immigrants and minorities.
In a year or two the cycle of subprime lending will return to liberal underwriting guidelines. Make no mistake, subprime lending is needed and is beneficial. Hopefully we in the real estate industry have learned the lesson to practice our profession responsibly by ensuring that borrowers understand the risks and realties of subprime mortgages. If we don’t, we are doomed to repeat history.
This column is not intended to provide nor should it be relied upon for legal and financial advice. This article was originally published in the Montgomery County Sentinel the week of March 26, 2007. Copyright © 2007 Dan Krell.