Magazine article Mortgage Banking

Branching out into Subprime

Magazine article Mortgage Banking

Branching out into Subprime

Article excerpt

Traditional mortgage lenders serving prime-quality borrowers face a unique opportunity today to branch into subprime. With consolidation under way in subprime, traditional lenders could recruit experienced subprime talent that could lay the foundation for becoming full-product menu lenders.

In September 1992, A colleague of mine, Jim Hennessy, published an article in Mortgage Banking called "Stocking a Full Line." The article pointed out the then-novel concept of traditional mortgage bankers offering a full line of products including subprime and consumer loans. With all due respect to Jim, the concept was embraced by virtually no one at the time. Why? For most, the attitude was simply "that's not our business," or "those aren't our types of customers."

Then, shortly after that, the 1993 refinance frenzy left no time to consider alternative product lines. When the refinance boom of 1993 ended with a thud in the spring of 1994, the industry was in such disarray that no one had the time or energy to discuss new strategies. For many, the focus was on surviving the year.

Fast forward to the present: Of the top 20 mortgage bankers in 1997 (measured by loan volume), fully 14 of them are now engaged in the origination of subprime loans. Strategies differ, but the majority of these market leaders realize the value of adding subprime to their product offerings. Some are doing well; others are struggling, but the majority are attempting to originate subprime products to reposition themselves and improve returns. This article examines the reasons for this sea change, from both a strategic and tactical perspective.

As a veteran with 20 years in consumer finance and subprime lending, I have always been a bit perplexed that mortgage bankers tend to define themselves by what they sell, rather than by what they do for their customers. If one walks around a mortgage banking conference, you're likely to hear people refer to themselves as: "I'm a conventional lender," or "We're primarily in the government market," or "We do a lot of 'Alternative A' business."

Well-positioned mortgage bankers of the future will define themselves by the value they add to their customers, rather than by what products they have on their rate sheets. Let's examine why.

Strategic considerations

Almost all senior mortgage banking executives predict that conforming margins will continue to compress, primarily because of competition caused by industry consolidation. There is every reason to think that the same thing will happen in the subprime sector, especially as the subprime industry undergoes its consolidation this year.

Granted, margins on subprime products are still huge when compared with conforming, but competition has already taken a lot of the easy money out of the subprime business. Privately, subprime industry executives are complaining about tougher competition, a slowdown in production growth, shrinking margins and excessive prepayment speeds.

What impact will this situation have on today's subprime originators? That's easy: It will force them to begin to examine the cost side of their businesses or risk extinction. Most subprime originators have huge salary and incentive costs, coupled with low levels of technology. Historically, huge margins also covered a lot of errors in underwriting, projections of loss and prepayment speeds.

What about conforming originators? They've lived with margins on wholesale loans of between 50 to 75 basis points for a long time, and perhaps 100 basis points on the retail side, both of which assume generous servicing valuations. To maintain efficiencies with these margins, conforming mortgage bankers ruthlessly track costs, have made significant investments in technology and are extremely savvy in the secondary market. All of these strengths position the conforming lender to take advantage of the coming subprime shakeout. But this will happen only if they realize these strengths and have the management fortitude to leverage them against a product line not traditionally part of their core business. …

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