What is Sub-Prime and Why It Matters

| March 6, 2007

[UPDATED 03/09/07 — 15:41 MST]

GE is cutting staff and ending no-down-payment mortgages.

[UPDATED 03/08/07 — 07:41 MST]

New Century (#2 sub-prime lender) calls it quits; the question now is how long until WAMU, Wells Fargo and Countrywide start to show signs of the financial pressure they are under, too. The unwinding of the Yen carry trade is causing the leverage all of these companies used to now work against them. Here’s a quote from New Century’s 8-K form that it just filed with the Securities and Exchange Commission:

As a result of the Company’s current constrained funding capacity, the Company has elected to cease accepting loan applications from prospective borrowers effective immediately while the Company seeks to obtain additional funding capacity. The Company expects to resume accepting applications as soon as practicable, however, there can be no assurance that the Company will be able to resume accepting applications.

Hat tip to Calculated Risk, which also points out that New Century may be on the verge of declaring bankruptcy. At the same time, New Century is facing a criminal probe, its stock price has dropped 70% in the past week, and its financial woes may have a ripple effect on other firms.

[ORIGINAL POSTING]

The US equities markets (stocks, bonds, commodities) have been all over the map in the past week. There are several reasons, a few of which I have already mentioned. One that is starting to get air time is the “melt down” in sub-prime lending. The common perception (fueled by the media reporting) is that we are talking about small loans to poor people who are taking a shot at owning a piece of the American Dream. Makes for a wonderful story, but reality is actually quite different.

The sub-prime encompasses people who have bad credit, as well as people who are doing risky things with their money; let’s look at some examples:

Low Credit Score – folks with a low credit score that maybe had some problems in the past, or maybe little or no credit history. This is the traditional “sub-prime” customer. It’s easy to think of some young family starting out wanting to own their own home and think “this is a good thing”.

High Loan To Value – the traditional mortgage saw the borrower bringing at least 20% of the purchase price into the deal. This was their “down payment” or earnest money. Recently this has gone completely out of fashion and we have seen 90%, 100% even 110% money on the price of a home. That means all those folks (especially in California) who bought those wonderful new houses with no money down – they are probably sub-prime. If they had good credit (FICO over 660) they are what is called “Alt-A”, which by the way falls into the same bucket when you hear someone in the media talk about “sub-prime”.

Low Documentation / No Documentation – yes, it’s true. Up until (probably this week) I could have walked into a mortgage shop and gotten pretty much whatever I wanted, and said whatever I wanted on the application. I could have told them I clear $20,000 a month and not provided a shred of documentation that I even had a job. This is how you hear about people buying 7, 10 , 15 houses and they work in a job paying less than $30,000 a year. They simply got their loan as a no-doc or low-doc / stated income. This is also sub-prime or alt-A. This is the primary funding vehicle for the thousands of flippers.

High Debt to Income Ratio – some folks who make a bunch of money also have a lot of debts. That could include credit cards, car payments, medical payments, you name it. If the amount of outstanding debt they have goes beyond a certain fraction of their yearly income, it is considered a risk (even if there is a good history of timely debt service). This would also cause people to have to get sub-prime or alt-A loans.

Theft / Greed / Fraud – let’s face it, the people selling loans to folks were getting payed a lot more to push this junk than they were regular mortgages. There are any number of accurate stories of how things got switched out during the closing process and folks wound up with a sub-prime loan when they qualified for a regular prime mortgage. People tried that on my wife and I when we purchased in 1997; I’m sure it only got worse.

Refi / Home Equity / Debt Consolidation – believe it or not, most of this paper is also considered sub-prime. Even if you have good credit, the mortgage people tended to funnel this through the sub-prime channels. It was easier for them to sell to the bond market, they made more money on you and everyone was happy.

As you can see, sub-prime is a lot more than that young military family scraping together enough cash to buy their first, modest home. In the past 5 years it has ballooned to encompass a surprisingly large amount of the debt creation in this country.

When you read that sub-prime is caving in, it’s correct to get worried, and here is why: (fun facts about what happens next)

  • With sub-prime gone, you remove the funding for most of the entry level buyers. Think of it like plankton, they are the “entry level” organism in the world oceans. Without them the higher order creatures pretty much cannot exist. In terms of housing, without entry level buyers, nobody gets to sell and move up.
  • The housing “wealth effect” is gone. One big story yet to come is how much of the conspicuous wealth that everyone had one display in the form of expensive cars, lavish lifestyles, amazing vacations was due to them taking “equity” out of their homes. Money that did not really exist. With sub-prime gone that use of the house as an ATM disappears. So what if Bob and Nancy don’t get to go to Fiji for 2 weeks you say? That money they spent caused jobs to be created, work to be done and expansion of our economy. With that flow of money gone, the benefit it brought is likely to disappear.
  • Housing speculation is done. People used the access to nearly unlimited funds to drive up the prices of houses everywhere in this country. In many cases they are now well beyond what anyone making a normal living can afford. If “flippers” cannot buy up houses while using none of their own money, that whole cycle is no longer viable. As a result prices really have no where to go over the next 6 years but down until they come back in line with what people actually make.
  • Increase in defaults, bankruptcy and foreclosures – it has already started in many parts of the US. People got carried away mostly because it was so easy to get the money. Like most folks they don’t really take the time to figure out how they will re-pay all they borrowed. They probably assumed that the value of their house would continue to go up, and if they got under water they would simply re-fi and get more money out of the house ATM. As we saw that is no longer available, and as a result folks will have to pay up what they owe. For many this is simply mathematically not possible. As a result the amount of financial distress will be epic, and as of today it is just getting started.

Let me end on a good note. Wringing all of this nonsense out of the market is a good thing. In the future our children and their progeny will have a clear cut lesson of how not to do it. Each down turn sows the seeds for a better day to come. This one will be no different.

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Category: Credit Backlash, Economics, Main

About the Author ()

Bruce Henderson is a former Marine who focuses custom data mining and visualization technologies on the economy and other disasters.

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