Vanishing Subprime is a Shame

December 13, 2009

Why Former CEO of First Franklin Says the Vanishing Subprime is a Shame.

One of the innocent victims of the financial crisis may surprise you: The subprime lending industry. Or so says a former subprime CEO. Irresponsible choices by the government and GSEs - not just the go-go subprime market - have paralyzed the American dream, he says. Newly revealed problems with FHA only add to the angst.

"It's gotten to the point where the word ‘mortgage' has a negative stigma," says Andrew Pollock, former CEO of prominent subprime lender First Franklin, which was once part of Nat City and Merrill Lynch. "A majority of subprime loans were common sense lending and investment quality that allowed the dream of home ownership to come true. Now subprime has a stink thrown on it, like kryptonite has been rubbed all over it." Contrary to popular belief, subprime loans were not contrivances created in a rush for profit before the housing bubble burst, says Pollock, now managing partner at Global Logic Advisors, a management consulting firm based in Redwood City, Calif. They have been viable products for decades, dating at least to the 1944 GI Bill that provided low-interest, zero-down payment loans to veterans.

"There's nothing inherently wrong with subprime lending," agrees Paul Fried, managing director of Traxi, a corporate finance and real estate investment banking consultancy in New York. "There is nothing wrong with the idea that you can provide loans for home ownership and a portion of those loans can be riskier, offered to people who don't have the most pristine of lending criteria."

Former bank CEO John Mason, who at one time served as a HUD official, agrees. "It's the American way. In the minds of some people, it's almost a right," says Mason, now a finance professor at Penn State University. "We have for years in America felt that home ownership is a very important thing," leading to many government programs and policies. This has ranged from the thrift charter to FHA loans to HUD's Section 8 program that provides vouchers to help low-income families buy homes.

"There has been an overreaction," Pollock says. "Clearly, there were abuses and inaccurate assumptions across the board: Banks, lenders, regulators. The blame game is very broad and very deep." But it has led to a severe reaction by reluctant lenders, despite low rates and government efforts to prop up the mortgage market with new programs. "We now have undermined those most deserving of home ownership" - fully employed, credit worthy buyers who would make full documentation, arm's length purchase transactions, he adds. First Franklin labeled its subprime loans as "non-prime" because it originated higher quality loans with stronger credit and capacity histories, Pollock says. In many instances, the borrower profiles had prime lending characteristics, but preferred a subprime product: 100% financing and alternative income documentation for underwriting qualification.

FHA Could be the Next Subprime Crisis

A portion of the problems with subprime loans can be traced to government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, Pollock says. And now, similar issues are emerging with the Federal Housing Administration (FHA), which provides mortgage insurance for loans made by approved lenders, who then bear less risk of a default. It is that approved list - which included the now-bankrupt Taylor Bean & Whitaker - and FHA's loose guidelines that have come under scrutiny.

"I'm really scared about FHA," Pollock says. "They are the biggest subprime lender out there, and the government will have to continue to prop them up. I lose sleep at night thinking about FHA's problems."

Concern about FHA emerged after an auditor's report last month showed that FHA capital reserves have plunged to $3.6 billion from $12.9 billion, or just 0.53% of the $685 billion in loans it insures. The statutory minimum is 2%. The agency is self-financed by borrower premiums. But the government ultimately is responsible for claims by lenders and there are concerns a bailout may be needed.

"There are real risks to the FHA, and we are aggressively addressing those real risks with real reforms," FHA Commissioner David Stevens said in a prepared statement. He attributes the decline to the collapse of the housing market and notes that the 0.53% ratio represents funds held in the Capital Reserve Account and does not include funds held in its Financing Account to pay for losses on existing loans. The two combined would come to $31 billion, or 4.5% of insured mortgages.

Last week FHA proposed regulations to require lenders to meet much higher capital standards and hold them responsible for underwriting performed by brokers on their behalf. HUD Secretary Shaun Donovan also told Congress last week that FHA will raise its minimum acceptable FICO score, reduce the amount sellers can contribute to closing costs to 3% of the sales price from 6%, and increase the required down payment from 3.5% to an amount under review. (The cap is 5%.) He also asked Congress to approve higher premiums nearer to the 3% cap from 1.75%. Earlier, FHA halted its seller-financed down payment program and tightened underwriting standards on refinances.

The Good, Bad & Ugly of Subprime Lending

The real issue is the definition of subprime, Fried says. The type of lending described at First Franklin is legitimate, necessary and, in some ways, even noble, encouraged by government programs. But other lenders delved into what Fried calls "sub-subprime," or lending to speculative buyers whose sole purpose was to flip properties, untied to residential needs.

"What bothers me most is use of the term ‘subprime' as a cover for the industry and the government's failure to go after fraud and gross negligence," Fried says. "It's a problem when an originator makes a loan to someone they know has no income. It's not the program, but the criteria and the abuse by people who benefit by making the loans."

Mason argues that such abuse did occur. The fundamental assumption of many underwriters was that home prices would go up indefinitely, he says, and as a result cash-poor, low-income borrowers who took out no document, no down-payment loans could refinance into a regular mortgage in three years using the equity that resulted from inflated housing prices.

"My gosh, this mortgage banker guy says he has a way to get me into a house,'" Mason recalls such borrowers saying. "What are you going to do? We dealt with this at HUD over and over again. What do you do with someone who doesn't have the experience or understanding of how to manage money or maintain a property? Yet you put their dream out in front of them. It's an easy sale. People will take advantage of that. And the mortgage banker just sells the mortgage, which is packaged and sold over and over. Who has the risk?"

There also is no comparison between VA loans and subprime, insists Nelson Bayne, mortgage compliance officer at St. Casimir's Savings Bank ($105 million) in Baltimore. "Yes, the veteran can borrow his closing costs. But this is in no way an un-documented file," he notes. There are no concessions on documentation, income verification, down payment or credit review, though there is a reduced rate to provide funds to cure the loans. If the worst happens, "The VA takes the properties back and resells them," he says. "Subprime lenders are requiring me to make up the losses."

But there were problems with the GSEs, Pollock says. "You see the Fannie Freddie guidelines stretch over time," he says, citing low-down-payment programs such as Freddie's "Home Possible" program for first-time homebuyers and low- to moderate-income borrowers involved in public safety, public health, education and the armed forces. "These were loans we would not approve at First Franklin, but we would put it under Desktop Underwriter or Loan Prospector, and they were approved," Pollock says, referring to Fannie Mae's and Freddie Mac's loan approval systems. "We would scratch our heads and say, ‘How?'" On the other hand, there also were small business owners whose income could not be substantiated under normal Fannie/Freddie guidelines because it often was poured back into the business. Those loans made sense to First Franklin because the borrowers had a proven ability to meet their credit obligations.

But with Fannie and Freddie pushing to increase sales volume, underwriting guidelines "started to stretch everything," he says, with lenders requiring only one or two trade lines over a limited time horizon rather than three lines over 10 years, as First Franklin required. "We had people out in the field saying, ‘We are too conservative in our guidelines because we are turning down loans that are being approved by Fannie Freddie or the nefarious competitor down the street," Pollock recalls. "At some point, all bets are off, even if you were the most studious lender out there," he says. Once the bubble burst, it burst on everyone. "Given the economic storm, a retrospective view of the highest quality loans is not relevant if an individual is unemployed and their home value is underwater. The house will still go to foreclosure." The regulatory and investment environment has shifted so broadly that subprime loans can't be held or sold any longer, Pollock says. The subprime lending industry "has gotten painted like Enron or WorldCom," he says. "Those loans will go to hard-money lenders: Individuals who pool money and lend at exorbitant rates with lots of points and fees. It's going back to the dark debt collection ages, when Moose and Rocco would make the brass knuckle collection calls in person going door to door."

That is a shame. "There was great opportunity for great business, and we helped a lot of people obtain the American dream," Pollock says. "They were prime borrowers with non-prime products."