Welcome to "The sub-prime forum," a column designed to help improve your knowledge of alt-A lending and offer tips to increase your share of this lucrative market.
As a 12-year veteran of the industry, Richard Bitner has a wealth of experience working in retail, wholesale and correspondent sub-prime lending. He has served as the president of Kellner Mortgage Investments for the past five years.
The sub-prime industry is in the process of going through some radical transformation, and it appears as though the process will be challenging. Unless you strictly do "A" paper mortgage loans, which few of us can afford to do in a slowing market, you've probably started to notice something unique taking place. Sub-prime interest rates are finally starting to go up.
Alan Greenspan recently made an interesting comment when he said that we've forgotten how to price for risk. Sub-prime lending was clearly at the core of his comment. If you've only been in the mortgage business for a few years, you've not had the pleasure of living through what I call a realistic market. By realistic, I refer to the fact that rates actually do go up and that residential real estate markets do slow down. We've all been the beneficiaries of the single greatest run in the history of the mortgage business, and it looks like it's finally headed for a change.
When I opened my sub-prime company over five years ago, there were no rates offered below 10 percent, including the adjustable-rate products. The weighted average coupon for most sub-prime loan pools was in the 11 percent range. In the spring of 2001, rates started dropping, and we all began playing the game of "how low can you go." As the real estate market continued to set new records each year, the collective appetite for sub-prime products amongst lenders and Wall Street investors grew at a phenomenal rate. When the federal funds rate dipped to one percent, many lenders were offering products to mid-to-low-500s credit score borrowers that were in the six-seven percent range.
Since the Federal Reserve began increasing rates in early 2003 at a measured pace, the rates offered to sub-prime borrowers have held fairly steady throughout this time. Subsequently, the pricing for this product has slowly eroded, with lenders gradually earning less and less during the last two years. In late October 2005, Wall Street investors finally pushed back on the market, and suddenly there was an additional reduction of 40 to 60 basis points in price on similar loan pools that had traded just two weeks earlier. Suddenly, almost every sub-prime lender in the market found himself taking loan trades at a loss. This includes some of the largest players in the market. When you consider that most sub-prime lenders pay an average of one point to the broker in yield spread premium, it's impossible to make a profit on this product when you turn a trade for 101.75. Between yield spread premium, account executive commissions and, of course, the general overhead necessary to run loans through a lender's operational system, trades at this price won't keep lenders in business for very long.
For an industry that has been rife with opportunity for the last five to 10 years, a new reality is starting to set in for many sub-prime lenders. The reality is that the market must begin adequately pricing for the risk on these borrowers or be prepared to face the consequences. The consequences could come in the form of increased loan losses, which could spell a rough road ahead for many industry players.
The next three-six months will prove to be significantly critical with respect to how the sub-prime side of the industry shakes out. In an environment where profits get squeezed, several options start to present themselves. Either companies shut down and take their money off of the table, downsize significantly to reduce cost structure, merge with other lenders or get forced out due to a lack of liquidity. It's my belief that you'll see this entire spectrum of events taking place in the wholesale sub-prime arena in early 2006. Even as I write this article, numerous lenders have already reduced the size of their operational teams in an attempt to battle against the reduction in margin.
During most of October and November, rates have on been on a steady climb. If the Federal Reserve continues to raise rates, look for most sub-prime lenders to follow suit. Those who don't will be asking for a lot of trouble. While the federal funds rate doesn't directly impact mortgage rates, it certainly impacts the cost of funds, which will continue to significantly impact the direction rates head in the future.
So, what does all of this mean to you, the mortgage originator? To put it simply, the best thing you can do is prepare yourself mentally for a sub-prime rate environment that is steadily increasing. It can be a hard pill to swallow if you are fairly new to the industry and all you've ever known are sub-prime rates like we've seen over the last two years. To accept the reality that rates will continue to rise will only help you with the mental part of your game. Remember that five years ago, most sub-prime borrowers used to pay 11 percent for an adjustable rate mortgage. It's not entirely inconceivable that they will again sometime in the near future.
In addition, make certain you have your relationships in place with your wholesale companies. This is going to be critical for several reasons. In the typical world of sub-prime lending, rate movement has historically been stagnant, with minimal rate movement on a day-to-day or even week-to-week basis. If you believe in the notion that sub-prime rates are on the rise, it's critical that you understand what lock options you have with the various lenders you utilize. Unlike "A" paper lending, locking loans in sub-prime has typically not been as critical. Some lenders won't lock in a deal until the loan arrives, while others will provide you with a lock mechanism prior to submission.
For example, at my company, we utilize our automated pricing and pre-qualification tool, Kwik Kwal, to assist brokers with placing deals. We've trained our brokers to utilize the system and print out the results of the deal they plan on submitting to underwriting. Once they print out their submission form, even if they haven't submitted a loan, they've secured their rate for a 30-day period, regardless of any rate movement that may have taken place. Whatever the approach your lender uses, make certain that you clearly understand what you can do to price-protect yourself.
One of the biggest risks you face in a rising interest rate environment is having a loan at a lender shop not fund because the company goes under. There is no formula I can provide you with to guarantee you that one company will make it while another one will not. All lenders, small, as well as large, will face the same competitive pricing pressures, as markets continue to move. However, you can help yourself by staying closely tuned to how your sub-prime lenders continue to operate and service your business. Let's look at this further.
In most cases, the account executive that works for the sub-prime lender is the one who will serve as the primary source of information for you in regard to how that company is doing. As you work with your lender partners, continue to ask them how things are going and what changes they see on the horizon. If things are going poorly at a lender's shop and morale is low, it should become apparent to you through conversations with your account executive. Of course, a lender going through a layoff doesn't mean that the end is near. Hopefully, the management team in such an environment is working to calm employee nerves in an effort to get everyone focused back on the task at hand—closing loans. On the other hand, if you start seeing customer service diminishing and no one is returning your phone calls, will you be prepared with a backup plan just in case your primary lenders begin to falter?
Another reality we're starting to see in the market is that some lenders have begun to pull away some of their more aggressive niche offerings. I suspect this will continue to varying degrees over time. As the appetite for sub-prime has increased over the last few years, more and more innovative product offerings have started to show up on the street. As lenders have worked to continually position themselves at the forefront of industry product offering, some have done so at the expense of logic. Yet, the good news for the broker community is that as long as lenders continue to push the risk envelope, there will more creative ways to get the borrower financed. The bad news is that at some point, the products that truly don't make sense from a risk standpoint will disappear. History has proven to us that when these products do go away, it won't be with a 30-day window to clean out your pipeline.
My objective is not to paint a doom-and-gloom scenario, but rather to assist you in being prepared to handle a changing marketplace. Unlike previous rising interest rate environments, there were never as many choices for programs and lenders in the sub-prime and alt-A markets as there are today. Without question, this segment of the market will continue to flourish with lenders lined up, ready and willing to handle your business.
If you've read any of the previous articles written in this series, you know that I'm a big proponent of building strong working relationships with just a handful of sub-prime lending partners. The best loan officers in the game understand the value of having top flight account executives and sub-prime companies they can turn to get their tough deals funded. Working your business plan with this strategy in mind will provide you with the foundation for longevity in the mortgage business. Then again, it never hurts to have backup plan, just in case.
Richard Bitner is president of Kellner Mortgage Investments, a nationwide wholesale sub-prime lender based in Plano, Texas. He may be reached at (866) 416-9995 or e-mail [email protected].