I reported in past articles that lenders have responded readily to a growing market of "B" & "C" borrowers. A borrower classified as "B" or "C" is considered sub-prime. However, this so called "sub-prime" category is a rapidly expanding segment of the residential mortgage industry.
In 1995, 169 Billion (that is billion with a "B") dollars of sub-prime loans were originated in this country. In 1996, 181 Billion were originated. Projections forecast an annual growth rate of 10% between now and the year 2000. Why is this happening? What is driving this segment of the market? How are these borrowers able to get loans for the many reasons that people borrow?
Let's address several categories of sub-prime borrowers. The first concerns consumer debt. Today the United States has a population with very high consumer debt. Most of this consumer debt consists of auto loans and leases, installment debt for furnishings, and revolving credit card balances. Consumer debt increased by 13% in 1996. Consumer credit delinquencies are rising.
There is also a tremendous growth in bankruptcy filings. In 1996 and for the first time in history over one million bankruptcy cases were filed. Statistically, in this country, 2.6% of everyone over the age of 16 has declared bankruptcy. Over the past few years we have seen a much higher debt to income ratio (the percentage of one's income that goes to service the monthly debt expenditures).
The second category of sub-prime borrowers and another reason for the growth of this sub-prime class, is that there are no guarantees an individual will have his/her job. We look for two years of employment stability on the loan application. As many of us know, there are no guarantees as to employment today. Surveys have shown that 25% of employed people have a fear of losing their jobs. Who knows what will happen tomorrow?
Another sub-prime class of borrowers is a growing immigrant population and an increasing number of young people (25-35) who want to purchase a home. These two groups are the fastest growing demographic segments of the residential real estate market. However, their limited credit history may make them potential candidates for sub-prime rating.
Because of the situations outlined above, loan originations have become and are becoming riskier. Lenders with investors on Wall Street are developing criteria that will anticipate and hopefully predict defaults. The main focus will be on credit scoring standards that will foretell the viability of the borrower. Both the combinations of the credit score and the loan to value ratio of the property will determine the interest rate for the sub-prime borrower.
I described in previous articles how FICO (Fair, Isaac and Company) matrixes will be the standard by which the borrowers' credit worthiness is to be judged. A high score indicates a lesser degree of risk to the lender. A score of 700+ is determined to have the lowest potential rate of foreclosure. Ranges in the low 500s will have the highest degree of risk to the lender. The correlations of credit score and loan to value will be the determining factors as to the interest rate charged on a loan. Determination of risk by using a standard matrix is affording lenders the ability to sell these mortgages as securities on Wall Street. Lenders can put together blocks of mortgages (loans) and sell them to investors.
Both investor and lender agree as to the potential risk level of the portfolio. If there were no set criteria as to perceived risk, lenders would be unable to sell and investors would be unwilling to buy. Thus, we would be looking at most of these loans requiring an interest rate much higher than what is available today. By so structuring these criteria, institutional lenders now can make loans that only a few years ago would have been made only by the so called "hard money lenders" with much higher interest rates and many more points. Copyright © 1999, jjrmf.com