FINANCIAL SURVIVAL IN UNCERTAIN TIMES

by Deborah Smith Pegues

Subprime Lending
Borrowers and Bankers Gone Wild

We can lay the blame for the U.S. economic crisis at several doors. The consensus is that subprime lending was the match that lit the fire that threatened to consume the entire world financial system. Further, there is still much debate as to who should be blamed for the fallout of these subprime loans. Since many people remain confused about the meaning and mechanics of such loans, let me attempt to provide a basic understanding.

Understanding the Subprime Debacle

Subprime lending describes the practice of financial institutions providing credit to borrowers deemed “subprime”—that is, those whose credit qualifications are less than ideal or “prime” using traditional criteria. These borrowers include those who have a history of a loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience. Further, their FICO credit scores (explained below) usually fall below a certain level.

Historically, banks made home loans based upon three primary factors: creditworthiness, cash flow, and collateral. Creditworthiness is determined by the borrower having an acceptable credit history as measured by a FICO score. FICO stands for Fair Isaac Corporation, the entity that came up with the methodology which reduces your credit history to a three-digit number ranging from 350 to 850 with ratings as follows:

• Excellent: 750 and over
• Very Good: 720 to 750
• Acceptable: 660 to 720
• Uncertain: 620 to 660
• High Risk: less than 620

Most lenders, or any entity extending credit, view the FICO score as the primary predictor of future credit performance.

During the subprime lending craze, loans were extended to borrowers with scores below 660 (albeit at high rates), increasing the risk of default. (I’ll explain the nuances of the FICO score in chapter 8, “Master Your Debts.”)

Cash flow is simply a measure of your ability to make the mortgage payment based upon your income and existing expenses. Traditionally, lenders used an average qualifying ratio of 28 percent/36 percent. This meant that your total mortgage payment (including principal, interest, property taxes, and mortgage insurance if required) could not exceed 28 percent of your gross income. When added together with all other contractual debt (auto loans, credit cards) the total (including the new mortgage) was not to exceed 36 percent of the gross income of all parties included in the loan application.

One of the most irresponsible concessions lenders made was to qualify borrowers based on “stated income.” Yes, you read right— income as stated by the borrower. The lender made no effort to verify the annual income by reviewing tax returns, 1099s, W-2 earnings statements, or other means of confirmation. The only documentation was what the borrower “stated” his income to be. This was a particular advantage for self-employed people who had usually met strong resistance from lenders in proving their income. Some jokingly referred to such loans as “liar loans.”

Subprime lenders also began to offer “teaser rates” or special terms that served to lower the payments during the first few years of the loan. For example, assume that Larry the laborer obtained a $300,000, 30-year loan at 4 percent interest-only for the first three years. The loan agreement further states that after three years, he would start to pay principal and 6.5 percent interest. Now, Larry and his stay-at-home wife, Lucy, are happy. Their loan payment (excluding property taxes and insurance) is only $1,000 per month for the first three years. Larry earns a fairly stable income of $48,000 annually ($4,000/month) at a local construction firm. The terms of his loan allowed him to easily meet the lender’s relaxed qualifying ratios, which required total gross income of about three times the monthly payment, or $3,000 per month.

To boot, the lender offered even more generous terms. They told Larry that his total debt commitments (including his mortgage) could go up to 45 percent or more of his gross income (versus the traditional 36 percent). This worked out well since Larry and Lucy both had outstanding auto loans on their two gas-guzzling SUVs with combined payments totaling over $600/month. Larry obtained the loan in his name only because Lucy’s credit was

At the end of the three years, Larry’s mortgage loan resets, and he finds himself responsible for principal and 6.5 percent interest payments on the $300,000 loan for the 27-year remaining term. His principal and interest payment is now a whopping $1,966, almost double the $1,000 he had grown accustomed to paying. His take-home pay is only $2,800 after taxes and various other deductions. He has two years remaining to pay on the SUVs. Larry is now committed to monthly payments of $2,566 ($1,966 new mortgage + $600 auto loans). He will have less than $250 for all other household expenses.

Larry now faces a financial crisis.

What we saw at the epicenter of the U.S. financial crisis were millions of loans that reached the interest rate reset date only to find that the borrower could not afford the higher payment due to inadequate income, higher food and fuel prices, and a number of other unfavorable economic factors.

Collateral is the value of property pledged as security for a loan. In the old days, a 10 percent down payment was the norm (the ideal was 20 percent), and every would-be homeowner saved toward it. Lenders knew that with such a big personal investment on the line, a homeowner was less likely to throw in the towel and walk away from a home when facing a financial crisis.

Some government-guaranteed programs allowed a 3 percent down payment for those who would have otherwise been denied access to credit and the American dream. However, during the subprime craze, many lenders waived down payment requirements altogether and made loans that even exceeded the market values of the homes. It was not uncommon to see ads touting loans up to 125 percent of the current market value in areas where homes were appreciating at a rate of 15 percent annually. The thinking was that real estate values would continue to increase at that same rate well into the future. The logic that a house in a market appreciating at 15 percent annually would be worth 30 percent more in two years seemed to hold water at the time. So, even if the borrower ran into financial problems, he could simply sell the house at a profit if necessary.

When we peek in on Larry and Lucy, we learn that their house is now worth only $225,000, and Larry is facing a layoff due to the downturn in the housing market. Looks like the bank and Larry were wrong in their assumptions.

Across the United States, this scenario was repeated by millions. Bankers and borrowers had gone wild and now had to face new realities as market prices dropped by up to 50 percent in many areas, leaving millions of under-collateralized loans.

Why didn’t Larry and Lucy do the math and determine if they would ever be able to pay $1,966 in principal and interest? Why didn’t the bank do the math? Why was everyone so shortsighted? Perhaps the mortgage brokers were too busy being salesmen? Perhaps the desire for bigger and better overwhelmed Larry and Lucy?

Everybody was at fault.

In the next chapter, we’ll look at what happened to Larry’s loan and at the fallout from this fiasco.