Subprime America: Good Credit Was No Shield

In the peak year of 2005, more than half of subprime mortgages were made to borrowers with prime credit scores. And last year “prime-subprime” borrowing hit 61% of all subprime loans originated, according to a study reported by the Wall Street Journal.

The Journal’s report reflects what many practitioners already know: A lot of borrowers were “upsold” into taking out subprime loans when they qualified for better, lower interest mortgages. In an industry where the compensation scheme for brokers — who largely work on commission — can reward the broker for selling a more expensive loan, this should be no surprise to anyone.

It never fails to amaze. Folks will shop a dozen car lots and look at a dozen homes before making an offer. They’ll haggle over an extra $200 on a car purchase or $1-2,000 on a home. (I know, I’ve done it!) Yet after winning the bidding war, they go to a loan broker — only one. And then, as long as the broker says something soothing –like “Here’s a great rate if we move on it fast!” — we’ll easily pay many times our haggled-for savings in higher interest costs in the long run. It’s not the price that gets ya; it’s the financing.

In real estate, many fell victim to a yield spread premium (”YSP”) fee — a fee paid by the lender to the broker based on the increased profit of selling the customer a higher interest loan than they qualified for. Brokers become very agitated if you call this a kickback because it is an important portion of their income. The broker in effect raised the price of the good being sold and split the extra profit with the maker of the good. That is a kickback.

No doubt a fair share of “prime subprime” loans were made to folks with good credit scores but other high-risk factors. Little or no down payment or equity. High debt-to-income ratios or with difficult-to-document income. Or buying rental, vacation or investment properties. The Journal indicates that as much as 41% of subprime loans were still from apparently-prime borrowers in 2000. (Of course the YSP was just as lucrative in 2000 as it was in 2006.) But it is fair to say a good FICO score is not the only measure of whether a borrower is really a prime borrower — they can default just like anyone else.

Ironically, although this means many people shouldn’t be wrapped up in the subprime meltdown and are in fact paying too much for their mortgages, the market is counting on these same people to carry on. The market hopes these folks will keep paying, regardless of how badly their adjustable rate mortgages go up. Their performance will help make the portfolios containing their mortgages look better.

After all, making sure mortgage bond investors still turn a reasonable profit is what everyone took out a mortgage for, right?