I started doing mortgage lending in 1996 with a sub-prime lender. It turned out this was the dawn of a liquidity crisis that struck the sub-prime secondary market through early 1998. I was only a loan officer and didn’t understand what happened to a loan after it was sold.

Later in my career, I spent 4.5 years working in secondary marketing of mortgages and better understood what had happened in 1998 and how the market has changed. Here’s my take on the future of sub-prime.

1) The number of mortgage lenders doing ONLY sub-prime lending are contracting and it will get worse for them.  In 1998, sub-prime mortgage backed securities were traded outside of the typical MBS market and were rated similar to junk bonds. All it took was a little bit of risk in that segment and new capital dried up.

Today, sub-prime loans are much more diversely securitized. Fannie Mae and Freddie Mac’s participation in buying subprime loans the last couple of years means that some sub-prime loans are tucked into conventional MBS issues.

Your true sub-prime securities are getting crushed right now and that means those lenders who ONLY do sub-prime and can’t diversify that paper are hurting. You can see why H&R Block is trying desperately to divest themselves of the financial albatross that Option One (a subprime wholesale lending company) has become for them.

2) The choices in sub-prime loans will diminish. Probably the biggest change you will see between now and next year is a MAJOR reduction in the use of 2/28 loans (2 year fixed rate loans). Federal regulators are looking at requiring lenders to qualify applicants on a 2/28 loan at the fully indexed rate after the first adjustment. Let me put that in numeric terms.

A 2/28 loan today could be at 7.00% for 2 years, often with a penalty for paying off early.  What regulators are considering is requiring the buyer qualify at the rate which this loan will change to after 24 months.  That same 7.00% 2/28 ARM would adjust based on the 6 month LIBOR (5.420) PLUS a margin of 6.00%-7.00% and a 5% cap on the first adjustment. That means the rate would go from 7.00% today to 11.42% at adjustment if the LIBOR stays the same. And regulators want to require lenders to qualify the borrower at that 11.42% rate.

The impact will be to kill the 2/28 in favor of the 3/27 which is probably .50% higher in that start rate for the first 3 years.

3) Lenders who have diversified and do all kinds of mortgages are best positioned to absorb these changes and continue to put the “top echelon” of sub-prime loans into less risky securities. 

4) In the short-term, mortgage brokers will be hurt hardest. Because lenders are increasingly taking losses on sub-prime loans, they are more likely to have more conservative guidelines for loans brokered to them vs. those originated by their own employees.

I’ve already seen several examples of loans that brokers can’t get approved but the broker is “losing” the deal to the same company through their retail group. There is no secret that loan fraud has a higher incidence rate in loans attained via a broker vs. their own employee (loan officer) which is why investment property financing has been harder of late although there have been hardly any guideline changes.

Tom, the biggest difference I see in this market over 1998 is that today, the largest sub-prime lenders are major financial institutions. If Option One were a stand-alone company they would be having a fire sale in my opinion. Because they are owned by H&R Block they have resources to make it through a short-term “hit”.

Long-term, sub-prime lending won’t go away becuase it is a much needed segment to provide homeownership opportunities. If Congress will allow HUD to lend to 100% that will really cut into sub-prime lending initiatives and offer a true low-rate and cost alternative.

Write your congressman!