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What's Next for NonPrime?

Our panel at the Mortgage Bankers Association's Nonprime Mortgage and Networking Conference believes there is a bright future for this segment.

Participants: Rick Glass, RT Glass & Associates; Patrick Weaver, president, Quality Home Loans; Loretta Salzano, attorney, Franzen & Salzano; D. Fred Baldwin, chairman, Lime Financial; James Hennessy, managing director, Capsilon FSG. Moderator: Lew Sichelman, housing correspondent, National Mortgage News.

LEW: We're meeting in a midst of a major meltdown of the nonprime sector. Some say it is a blip on the road and it won't last long and it won't be bad. Others say it is the beginning of the end of the business. Can you give me your own assessments of what you see out there?

FRED: I don't have the final answer, but it isn't over. It won't mean the end of the subprime business. It recasts itself about every 10 years. The parameters get too wide and things slide downhill. I think we've got the rest of the year. If the real estate market comes back, I think it will make that a little shorter time.

JIM: I agree with Fred in that it's not going the end because the demand continues unabated. People need the product and it is going to be offered in some form. However, the form in which it will be offered will differ widely than what we've seen in the last 12 months, when loans were made to feed a securitization machine and to bring a profit. It probably got in the way of some good judgment. The guys who have been in the business multiple decades would realize these loans probably shouldn't have been made. There are some people who don't get a loan. It is that simple. That being said, what is the landscape going to look like? Will we have the big monoline companies going forward? I tend to think we are going to see fewer of them. We're going to see more big companies, probably investment-backed, that will offer a variety of products. Yes, they will all be risk-based priced to some degree.

LORETTA: I agree I don't think it is the beginning of the end certainly and I've seen a cycle or two in my career and certainly for some of the problems we've encountered, controls have been put into place. In the secondary markets, the limitation on products and we've state and federal regulatory guidance that has changed the landscape considerably. I think that the industry has already responded and now is thinking about proactive ways to help keep consumers in their homes over the rocky six months to 18 months.

PATRICK: I agree and echo the sentiments spoken here. I think we saw an abandonment of the traditional guideline approach to subprime. It has been that high-profile lender with that high-risk loan (high LTV/low FICO) that has certainly led to the guideline right size. It is not the end but the beginning of the change.

RICK: This is a thriving sector, while there have been some challenges - a flight to quality, a tightening and repair - you're also seeing there is interest from the street. I'm seeing demand for talent. I'm still seeing companies doing things. That tells me (the industry) is not over. It is going to reinvent itself and it is going to be a more efficient machine.

LEW: I'm curious: who is to blame? I have heard that some people are pointing their fingers at mortgage brokers, others at Wall Street.

JIM: The answer is everyone, all of the above.

LORETTA: Consumers too have made decisions, which aren't always the best decisions for themselves.

JIM: There is the conventional wisdom among consumers that everybody has to get into real estate because it is appreciating so rapidly and it is the best path to wealth. And no matter if have to lie, cheat or steal, you've got to get into that house and certainly, the origination community was there to provide a means. Stated-income loans and more, they certainly created a demand in the mortgage banking sector, which in turned asked Wall Street. Wall Street says you are the guys at risk ultimately. If the loans go bad, you've got to buy them back. We're focusing on the expertise of the mortgage banking sector to provide the guidance here and be the bellwether of what will and won't work. So the answer is everybody, up and down the chain.

PATRICK: The mortgage is about risk and that risk is born by all players. The appetite for production outweighed that risk. We saw the proliferation of a mortgage product, which fed all of those interests and ultimately all of those parties, lenders included, obviously suffered as a result of it.

LEW: I'm wondering how the situation has affected your own companies?

PATRICK: We actually had dumb luck, or just call it fear. We veered from that product. So we are being heavily courted by the street and by potential employees. So we do expect growth. We are at this point, in the first quarter of 2007, this is a record-breaking year for us in terms of production. We will continue to grow, we will to continue to focus on originating a risk-adverse product in the subprime sector. I think we will come out even stronger.

FRED: As a more traditional subprime mortgage banker as Lime is, liquidity has gone out of the business. If you don't have cash, it is difficult to survive. You have to watch your cost tremendously. You have to flag to new guidelines. The business used to be done by portfolio lenders, Household, Beneficial, some of the banks. Wall Street came into the mix. I'm not blaming it all on Wall Street, but they've certainly led us into the mix with securitizations. All you can do to survive is to maintain your liquidity and that can be done a lot of ways. You have to cut costs drastically, you have to a flow basis (on the secondary market) in a lot of cases to make sure you can sell your stuff and that you don't have early payment defaults coming back. It is in flux now. Even the credit score companies come into the whole wide circle of what caused this. A 580 guy could be better than a 640 guy if you are looking at mortgage lates. The blame belongs everywhere and you just have to watch your dollars so closely. We've said there is no liquidity. But it is interesting because you talk to many of the players and there is liquidity. It just depends upon which product are you referring to. We use the statement as almost as its universal for the industry, when in reality, there is no liquidity for a product there should not have been liquidity for.

PATRICK: I was told by a number of people today that they would pay 103 or 104 for the right product.

FRED: I've gotten rate sheets today from a couple of investors paying all the way up to 105. From a product mix/product development standpoint, there is liquidity. We've not encountered the "liquidity crisis." But again we don't originate that product. The mortgage industry and all players involved need to start focusing on and communicating on is what is the message we want the marketplace to understand about our industry. Or do we continue fulfilling the notion that the entire market has gone to hell in a hand basket. There is just that generalized statement about in regards to the industry vs. specific historical performance details that clearly identifies traditional subprime product being originated today is still performing as it did 10 years ago.

JIM: The companies that are having issues had been staying in the deep end of the mortgage lending gene pool but they were dabbling in the shallow end and that was enough to get them all into trouble.

LORETTA: Our firm does compliance and litigation defense and we've got a lot of litigation, a lot of repurchase demands and we're defending those. A lot of the litigation on that side is related to mortgage fraud and now people have time to look for it. On the compliance side, we do have a lot of clients who have pulled back, and (taken) certain proactive measures. We're seeing, for some, sales and change of controls, so we're doing multistate work on those changes. Folks are expanding into new markets. We don't see folks expanding into new products, but into new states. And we see a lot of folks reacting to the nontraditional mortgage guidance and trying to figure what that means to them as far as policies and procedures and how far they can go while still delivering the product that they want to the consumer. So it is a balancing act.

PATRICK: I'm sure most of you are familiar with the manufactured home market, which was taken down right across the floor by certain companies. It became nonexistent. Nobody would buy that paper. Now all of a sudden the manufactured home business is coming back, it's come from the dead. So this other business, which is much bigger than manufactured, will come back.

LEW: Rick, with all of the people out of work, it seems to me that some of the stronger companies have the ability to find some really good people.

RICK: There is a window right now for every discipline in the sector for acquiring top high-caliber talent. I am talking about groups of people, a top producer and his staff or people in a certain discipline. Our practice has shifted. This has actually been our best quarter ever. In 1998, we looked to where the demand was, and saw it in production and operation and worked with people that had the greatest demand. After that correction in 1998, we started looking at the market and where it was going and where are the risks. We tried to partner with companies that are very well capitalized and we are seeing that today. We are migrating toward the Wall Street integrators and the large banks. We are seeing large demand in risk, loss mitigation, those particular disciplines. We haven't slowed down but there have been shifts where the demand is.

LEW: Angelo Mozilo has said, "You never know you're swimming until the tide goes out." We've seen a number of companies, 20 to 30, already have gone out of business. Do you think the worst is over or do you think there is a lot more to come?

FRED: I don't think it is over, but I think the majority of it has happened. I think there will be some more companies that at least will be acquired, either with a street firm or possibly banks. The number of people in (nonprime) is going to be cut way down after this. I think that is the only way you can control the underwriting, the whole presentation. The business has to be under more control than it has been. Household and Beneficial in the old days were great controllers of the business, ITT Finance and the rest of them. They knew what held in their portfolios. They could make deals with their customers who were delinquent. Believe or not they didn't foreclose that much. They got whacked by the government, which said, "You can't charge that guy three more points to re-up," but they saved his house from foreclosure. I think in six months it will be back up and running.

JIM: Mike McQuiggan spoke (at the conference) about the real test. We've had one wave of tests now, the early payment defaults. But the next wave could be in ARM adjustments. We will know more in the next 18 months, if the programs aren't available, are we going to see major forbearance, are we going to see government intervention, are we going to see the GSEs getting involved? Who knows? It is going to be a real adventure over the next year and a half.

RICK: There is a firm out there in this sector that has a $24 billion (servicing) portfolio, and they told me that 90% of the loans that adjust in the 2/28s are in default for 90 days and they are doing pre-adjustment mods to try and keep (the borrower) in the house.

LEW: Someone said that 80% of this market will be concentrated in the top 10 companies. Is that a real possibility? That has never happened before in the overall mortgage market.

FRED: I think there will be some small players zooming along, I would agree with that. Angelo has been saying that for the last five years. I agree there will be consolidation. The middle guys will be gone. There will be small fish on a regional or local landscape.

JIM: I think you are right. About 10 years ago, Brenda White said that there would be within five years about six significant banks in the country. A couple of them already have been assimilated into one of those. I think there is an excellent chance you will see a relatively small group of mega-lenders that are really dominant not only in this sector but in a multiline scenario. I don't know how it can happen any other way, especially as some of these portfolios go bad. There are too many things that are going on that point to that. I just don't know how long it is going to take.

LEW: It seems to me that it is a foregone conclusion that proper regulations and maybe even new laws covering the mortgage industry in general and the subprime sector in particular will be passed. What could you live with and what could you live without?

FRED: It is probably a conversation that goes on every day, in our offices for sure. A delicate balance, certainly. There are some proposed regulations that will help, but I'm not sure any will. At the end of the day, those borrowers will have to be able to access capital. Unless the lending community is able to do that in a way without creating unnecessary risk, you are going to wind up hurting the consumer more so than helping them.

JIM: I was in lending for a long time. Subprime for me started in 1990. And we're more regulated now than we were then, for the simple reason is, in a free market, you are going to get abuses. You are going to get energetic, aggressive people out there creating the product, originating the loans. As the loan become more complex, you are going to have to create more regulations, more disclosure and what have you. If we get to the point where we get federal pre-emption in a lot of ways, but especially in the disclosure area, things should become simplified far more quickly. It is a political football. You get everybody who is holding elective office, whether locally, state or federally, seeing an opportunity here with blood in the water. They can make a statement, call a press conference and somebody will say, "We need to control these lenders and we will do so by requiring new disclosures." Multiple by thousands of municipalities, 50 states, not to mention this is going to be an election year, so you are multiplying that potential for more regulations. With some kind of federal pre-emption or oversight that obviates all of these small regulations we are going to be far better off.

FRED: I think we are probably going to see subprime qualify fully indexed in the first year. Everybody feels ARMs are a destructive business, I'm not sure, but there is certainly a problem. The other thing is if foreclosures really get high, you are going to get a year or two of forbearance by legislation. You can foreclose but you have to work for a period of time without taking the house to try to shore the customer up.

PATRICK: I don't know how we deal with the potential onslaught of disclosures without otherwise literally destroying the marketplace. What that is and how that is ultimately implemented will certainly have to address how do you keep these people in those homes.

LORETTA: I'm not a lender, but whenever we go through something like this, and I think about the predatory lending legislation that swept the nation, our clients generally say they can live with two things. They can live with certainty. So don't give us a suitability test or a reasonable tangible net benefit test or something wishy-washy. Give us certainty and give us a level playing field. The people in this room have to compete with banks and folks who take advantage of a federal preemption. We might as well all play by the same rules and we all can compete fairly in the marketplace. But if we end up with a smattering of states that are coming up with foreclosure moratoriums, limitations on products or fees or some kind of federal legislation that does not apply to federally chartered institutions, which I think would be unusual but could happen, that is really when folks will squabble. At least if it is certain and you know what you have to do to implement it and you know your competitors are struggling with the same challenges, that is certainly far more palatable.

PATRICK: New York is positioning very aggressive in the forbearance area. There was an article with Sen. Hillary Clinton promoting such as well as the elimination of prepayment penalties for subprime. I think that might cause other states to follow. But I think it comes back to, if it isn't universally applied, if it is not consistent, you will have lenders pulling out of states, and you will have pandemonium in the marketplace. At the end of the day, I think those remedies will be at the forefront of the regulatory issues. For existing borrowers, how we will save homes, how will we enable borrowers who are unable to afford homes? There are trillions of dollars that we talking about here. Inevitably there will have to be a stopgap for the existing borrowers.

JIM: It makes you wonder. One of the answers you mentioned would be not a forebearance but a moratorium on court judgments which would hopefully keep the loans current.

PATRICK: That is the issue. You have got bond investors. There needs to be some kind of mechanism to keep the money flowing.

LEW: In a situation like that, the ones that would be hurt would be the investors. At the same time they would be hurt less than the loan going away completely.

LORETTA: Those foreclosure relief services or outreach services or hotlines are really not designed for what is happening now. Even the most recent ones, even though they were launched in anticipation of what was going to happen with the resets, they just don't have the funding to help everyone.

PATRICK: If not some sort of bailout mortgage, the forebearance would have to be the only viable answer. But it would only be viable if the bond market was somehow subsidized. Otherwise, the losses there could create, in and of itself, another catastrophe.

LEW: Has the industry been painted unfairly in the press?

PATRICK: I think that is an understatement. I think it is definitely an understatement.