CPA & Business Advisory Blog

Subprime Home Loans – A New Chapter

Wells Fargo, the largest U.S. mortgage lender, is slowly getting back into making subprime home loans. The bank is looking for opportunities to increase revenue, as overall mortgage lending volume declines. It believes it has dealt with its prior mortgage problems, particularly with U.S. home loan agencies, to be able to extend credit to borrowers who may have a higher risk profile. These steps by the bank could amount to a substantial change for the subprime mortgage market that brought the banking system to the brink of collapse. Since the recent financial crisis, banks have been reluctant to lend mortgage money to borrowers, except to those deemed to be the safest.

Any loosening of lending standards could boost housing demand from individuals who have been forced to sit out the recent recovery. However, there is the fear that U.S. lenders will, once again, make the same credit errors that contributed to the financial crisis.

Thus far, few other large banks seem ready to follow Wells Fargo’s approach, but some smaller companies, not in the banking system, such as Citadel Servicing Corp., are already increasing their subprime lending. To avoid the association with the past, lenders are calling the loans “alternative mortgages” or “alternative mortgage programs” instead of “subprime.”

Stricter Loans

Wells Fargo is seeking customers who can meet strict criteria, such as showing the ability to repay the loan and having a documented explanation for why a credit score is subprime. It looks for borrowers with credit scores as low as six hundred compared to the prior limit of 640, which often was seen as the cutoff point between prime and subprime borrowers. (Credit scores range from 300 to 850). As a result of financial reform, lenders remain cautious. Under the Dodd-Frank law, borrowers must meet eight criteria, including income tests and low amounts of other debt. If a borrower fails to meet those conditions, and later defaults on a mortgage, the borrower can sue the lender and argue the loan should not have been granted in the first place.

Building a Wall

The rules have helped create a wall between prime and subprime borrowers. Lenders have been avoiding those with credit problems and lower scores and, instead, have been catering to those legally easier to serve. Lenders have reasons to try to reach further down the credit scale now. Rising mortgage rates since mid-2013 are expected to reduce total U.S. mortgage lending in 2014 by more than 36 percent, primarily due to a large drop in refinancing, according to forecasts by the Mortgage Bankers Association. A recent report by the Urban Institute and Moody’s indicated that a full recovery in the housing market “will only happen if there is stronger demand from first-time homebuyers…we will not see the demand needed among this group if access to mortgage credit remains as tight as it is today.”

Making Up with Agencies

For Wells Fargo, a critical factor in its new strategy is clearing up disputes with Fannie Mae and Freddie Mac. The 2013 settlements for $1.3 billion resolved differences in a 5-year battle between banks and government mortgage agencies over who was responsible for losses from the mortgage crisis. The bank still has mortgage problems to clear up with the agencies, including a lawsuit linked to the Federal Housing Administration (FHA), but the bank officials believe the worst is over.

For Wells Fargo, a critical factor in its new strategy is clearing up disputes with Fannie Mae and Freddie Mac. The 2013 settlements for $1.3 billion resolved differences in a 5-year battle between banks and government mortgage agencies over who was responsible for losses from the mortgage crisis. The bank still has mortgage problems to clear up with the agencies, including a lawsuit linked to the Federal Housing Administration (FHA), but the bank officials believe the worst is over.

Wells Fargo avoided many of the worst loans of the subprime era. For example, It did not offer option adjustable-rate mortgages. However, when it acquired Wachovia in 2008, the bank inherited a $120 billion portfolio of “Pick-A-Pay” mortgages where borrowers could defer payments on their loans. Those loans resulted in big losses.

Banks are currently cautious because Freddie Mac and Fannie Mae have been pressing lenders to purchase back home loans that went bad after the crisis. The agencies guaranteed the loans and believe that the banks overstated the mortgages’ quality, or made mistakes in documentation.

Banks believe the agencies used minor mistakes as a means to pressure banks to purchase back loans. Following the settlements, Wells Fargo is more confident about the underwriting errors the agencies consider material, and the quality of the documentation needed to avoid such costly differences in the future.

Wells Fargo is not just opening up the lending faucets. The bank is looking to lend to borrowers with weaker credit, but only if those mortgages can be guaranteed by the FHA. Because the loans are backed by the government, Wells Fargo can package them into bonds and sell them to investors.

The funding of the loans is a key difference between Wells Fargo and other lenders.The smaller, non-bank lenders, are making mortgages known as “non-qualified loans” and are often holding them on their books, but the big banks are packaging the mortgages into bonds and selling them to investors.

Article written by Stuart Eisenberg, Partner and National Real Estate Industry Practice Leader at BDO USA, LLP.  It was originally published in the BDO Real Estate Monitor Spring 2014.

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