Subprime Mortgage Lenders - Past, Present and Future?

Subprime mortgage lenders had a lot to do with this housing collapse of 2008. They weren't the only cause, of course. But they represent the type of irresponsible lending that spread like a plague during the years leading up to the crisis.

Today, in 2011, you won't find any lenders willing to make subprime loans to poorly qualified borrowers. In fact, we've swung pretty far in the opposite direction. We've gone from subprime to super-prime. It's a lot harder to qualify for a mortgage loan these days. Just ask the rising number of would-be home buyers who've been rejected by lenders. 

But the days of subprime mortgage lending are not gone forever. Like a comet that returns to earth's atmosphere every few years, subprime loans will come back. Eventually. After all, greed is a fundamental part of human nature. So the desire for profits will someday override common sense, as it did during the housing boom. In fact, we are planting the seeds for the next crop of subprime mortgage lenders right now.

What is a Subprime Mortgage?

A subprime mortgage loan is a home loan given to a borrower who has a high likelihood of default. Based on their credit histories, income levels and debt loads, these borrowers are statistically more likely to default on their loans. A "default" occurs when you can no longer make the payments on your mortgage loan. To state it differently, subprime mortgage lenders are willing to give loans to people who would not normally qualify for a loan.

Bad lending decisions have been around since the dawn of finance. But the idea of subprime lending became an institution in the early 2000s... 

Looking Back - The Origins of Subprime Lending

The concept of subprime mortgage lending was born during the housing boom that started toward the end of the 1990s. Lenders realized the profit potential of making loans to "underserved" borrowers whom they had previously rejected.

These subprime borrowers, as they were called, had low credit scores, insufficient income, or other problems that prevented them from qualifying for a loan under normal standards. Driven largely by greed, mortgage lenders began offering loans to this large and untapped pool of buyers.

The subprime mortgage trend spread like wildfire throughout the lending industry. Companies like Ameriquest Mortgage (now defunct) focused on this business model almost exclusively. These companies became known as subprime mortgage lenders.

Over time, more and more lenders hopped on the subprime bandwagon. They did not want to miss out on the tremendous profits to be had. They wanted to protect their market share. They wanted to keep up with the competition and make their shareholders happy. So they relaxed their qualification criteria and created new loan products for under-qualified borrowers.

Subprime mortgage lenders outmaneuvered their competitors by giving loans to people their competitors were turning away. "ABC Lending Company said your credit score is too low? Not to worry. We have some financing options for you." This led to major shifts in market share, which brought even more lenders into the world of subprime lending. It was a matter of survival. If you wanted to stay competitive in those days, you had to offer loans to subprime borrowers.

Mortgage lenders charged higher interest rates for subprime borrowers. There were two reasons for this. First (and most obviously), it increased their profit margins. They also charged higher rates because there is a higher risk associated with these borrowers.

If somebody has a bad credit score, it's because they haven't managed their finances well in the past. They've had trouble paying their debts on time. Statistically, this suggests a higher likelihood of default on future loans, as well. Subprime mortgage lenders charged higher interest and additional fees to make up for this risk.

Supporters and Critics of the Business Model

These days, nearly everyone speaks poorly of subprime mortgage loans. "What a reckless business model that way. Just look at all the trouble it caused!" But during the heyday of subprime lending, there were just as many supporters as critics.

During a housing policy meeting in 2004, Edward Gramlich (who was on the Board of Governors at the Federal Reserve at the time) explained how subprime mortgage lenders were helping the country:

"Because of innovations in the prime and subprime mortgage market, nearly 9 million new homeowners are now able to live in their own homes, improve their neighborhoods, and use their homes to build wealth."

Harvey Rosen, an economics professor at Princeton University, explained how subprime loans (and other innovations in the lending industry) "gave many people the opportunity to own a home that they would not have otherwise had." True enough. But these same innovations contributed to unsustainable mortgage situations that inevitably lead to foreclosure -- for millions of Americans.

Today, in 2011, subprime mortgage lenders are more widely condemned. These days, you would be hard pressed to find someone with anything good to day about subprime loans. But that doesn't mean they won't make a comeback.

The Inevitable Return of Bad Loans

Have we seen the last of subprime mortgage lenders? Under that particular label, yes. There is no way the lending industry would reintroduce a mortgage product with such a negative image. Instead, they would re-brand it and call it something else. Nor would the federal government allow the reemergence of a lending trend that laid waste to the housing market. 

But there will always be endless greed in the mortgage banking industry (a powerful lobby group, by the way). And there will always be large segments of the populace with bad credit and other financial problems. So it seems inevitable that the former will devise new methods of offering loans to the latter.

In fact, we have seen some relaxation of the tougher post-crisis credit guidelines already. In February 2011, the New York Times reported that Wells Fargo was lowering the minimum credit-score requirement for FHA loans -- from 600 to 500. The lower number is clearly in subprime territory. Is this the beginning of another industry-wide erosion of lending standards? Time will tell.