In the run-up to the 2008 financial crisis, subprime loans were big business for everyone from mortgage brokers, to investment bankers.
Subprime loans were loans for homes that were given to subprime borrowers.
Subprime borrowers were borrowers that have credit ratings lower than 670.
It’s hard for subprime borrowers to get loans from traditional lenders.
What causes people have lower credit scores than prime? Well, it could be that they don’t pay their bills on time, or they have bills in collections, or they have had too many credit inquiries, something lenders consider an indicator of risk. On the other hand, having a bad credit score could be the result of none of those things; it simply could be that you’ve never taken out credit. If you’ve never taken out credit, there’s no way to assess your credit risk. Someone fresh out of college, or someone who simply doesn’t borrow money, will have a higher likelihood of a subprime credit score.
In my opinion, the way we score credit in America is flawed. In this new age of FinTech, there are companies out there betting on a different way, as shown in this article by the Huffington Post. From the article,
“Companies like PayPal, Kabbage, SmartBiz, Square, and others have stepped in to look at new ways to determine creditworthiness. Rather than depend solely on a single score like FICO, they are looking at a more holistic picture of a credit applicant. See https://marketsmedia.com/opinion-fintechs-dirty-secret/ for more.”
Credit rating, known as FICO score, for consumers does not consider a borrowers assets, only his/her liabilities, and timeliness in paying bills. This is not the case with corporate, mortgage, or government debt. S&P, Fitch, and Moody’s DO take into consideration the assets of an entity borrowing money via the debt markets. This is kind of interesting if you think about it. When a person wants to take out a mortgage to buy a house, the bank uses their credit score, which is determined solely on whether they have debt that they pay regularly, and on time. The reason is that bank’s want to ideally borrow money to customers who are willing to borrow money, and make monthly payments with interest. The reason is because the longer you take to pay off a loan, the more interest the bank makes. So the ideal customer is a borrower who borrows a lot of money, and pays on time every month for the duration of the loan (which is ideally a long time). This is why subprime loans were seen as such as opportunity for banks during the run-up to the crisis; subprime loans have a higher interest rate than prime loans. The bank can make more money on them. Combine that with the assumption that house prices would never decline substantially, it seemed like a very good way to make higher margins on loans. Based on this, banks even sold a lot of these loans to investors on the same pretext, that subprime loans were not a reflection of bad borrowers, but borrowers who had lower credit scores thru no fault of their own. The rating agencies believed this, and gave ratings on mortgage debt that reflected the thought that subprime and prime borrowers did not pose significantly different risks. With these equal ratings, banks packaged prime and subprime loans into the same mortgage bonds to sell to investors. Wikipedia gives us a few details into how this was done below:
“Earlier traditional and more simple “prime” mortgage securities were issued and guaranteed by Fannie Mae and Freddie Mac — “enterprises” sponsored by the Federal government. Their safety wasn’t questioned by conservative money managers. Non-prime private label mortgage securities were neither made up of loans to borrowers with high credit ratings nor insured by a government enterprise, so issuers used an innovation in securities structure to get higher agency ratings. They pooled debt and then “sliced” the result into “tranches“, each with a different priority in the debt repayment stream of income. The most “senior” tranches highest up in priority of revenue—which usually made up most of the pool of debt—received the triple A ratings. This made them eligible for purchase by the pension funds and money market funds restricted to top-rated debt…”
Translated, the banks that created these mortgage backed bonds to sell to investors used some quantity of prime mortgages that were issued and guaranteed by the federal government (via Fannie Mae and Freddie Mac) to artificially elevate the ratings on the combined package of prime and subprime mortgages. Therefore, when an investor bought a mortgage backed bond, he/she was getting a bunch of mortgages, some of them justifiably AAA rated, and the rest of them subprime. Let’s say a bond sold to an investor consisted of 70% Fannie Mae backed mortgages, and 30% sub-prime mortgages. These are two “tranches” of the same investment. Because of the Fannie Mae backed mortgages, the security is sold as AAA, even though it is exposed to the risk coming from the subprime holdings. When subprime borrowers defaulted (stopped paying their mortgages), losses accumulated. Initially, the losses were restricted to only those higher risk investors (e.g. hedge funds) who had bought strictly subprime “tranches”, but soon, when principal value of subprime mortgages started to fall, i.e. home values were tanking because of foreclosures, those losses made there way up to the AAA portion of the “hybrid” bonds. Suddenly even though the good mortgages were not defaulting (they were paying their bills on time), the investors holding those bonds were eating losses coming from sub-prime mortgages. Who were these investors that thought they had AAA rated bond portfolios? They were pension funds, insurance companies, and entities called conduits.
What are conduits? Conduits are legal entities created to fulfill narrow, specific, or temporary objectives. They are often called Special Purpose Entities. They are used by companies to fence off a part of their business from the rest of the company, such that whatever the outcome of the SPE, the rest of the company would face limited liability or risk. Conduits were the perfect way for banks get into the mortgage securitization business, i.e. selling mortgages as investment bonds. Here’s a little bit more color on SPE’s once again from Wikipedia:
“A special-purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE is not owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitization, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank’s group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore, many SPEs are set up as ‘orphan’ companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure that there is no connection with the sponsor.”
I mean, is this shady, or is this shady? So banks owned mortgage loans.
They wanted to securitize them into bonds (mortgage backed securities) and then sell them to investors.
This was huge business for banks, the securitization process, from a fees and commissions perspective.
It was easy money, pretty much riskless. There was risk in holding the securitized product in inventory before it was sold to investors. Why? Because banks knew securitizing loans in “tranches” was shady. It simply hid the risk from investors They knew that some of the subprime loans were no-doc, interest-only, in excess of 100% loan to value, and this very fact meant their risk profile was huge relative to a normal subprime or prime loan.
Does anyone remember a mortgage company named Ditech? According to Wikipedia,
“Ditech pioneered 125 percent loans that allowed mortgage loan applicants to borrow more than properties were worth. The loans were also low-documentation mortgages, or stated income loans, and many borrowers falsified their incomes.”
125% Loan to Value! They were based on the thought that homes never go down in value. Stated income was another hilarious creation; obviously, people used it to lie about how much money they were making. These loans immediately went into default when home prices experienced just the slightest hiccup. Because of this potential risk, banks took the securitization off their books, and onto the books of these SPEs they created. So the SPE encompassed the buying of loans, the securitization, and the selling of the resulting mortgage bonds. It worked. Until it didn’t. And when it didn’t, it didn’t in a big way.