Subprime Lending Reality Check

Even though they call them reality TV shows, you wonder about how close they are to reality. I am also always amazed at how we are so ready to abandon reality when it comes to financial affairs.  There is a reality to financial affairs that is very much rooted on common sense, and it works year after year after year, decade after decade.

Yet there are times when the "irrational exuberance" of people leads them to believe something different than what is reality based. For example, we know that the Price Earnings Ratio, P/E, is normally between 15 and 20.  Growth companies that have an ability to grow faster and produce earnings faster than the economy in general command P/E ratios that are higher than average.

Yet during the dot com boom, even concepts like earnings went out the window.  Valuations, if you can call them that, were based upon website traffic without any reference to how that traffic might be turned into revenue and, ultimately, earnings, at some point in the future.

Of course, we all know that in many cases, the management of those companies were spending a significant portion of their time flying around the world trying to attract the next level of financing as they spent money at a prodigious rate, what a friend of mine referred to as "spending their way to glory."  This process of going through cash without much revenue coming in actually got a name - burn rate.  That was the number of months the company could continue to spend money before they went out of business or attracted the next level of financing.

Of course, we know how that turned out. Stock market losses wiped out investment value. Reality finally asserted itself.

We have had a similar situation with subprime lending. It was obvious to everyone in the business that the subprime lenders had departed from this reality and were operating in a galaxy far, far away. Initially, I think that the parties involved really thought that traditional underwriting practices as developed largely by FannieMae and FreddieMac were out-dated.

There is some evidence to support that contention, should anyone want to make it. For example, when they developed their automated underwriting engines in the late 1990s, we quickly found out that the criteria they were using departed significantly from what their own underwriting guidelines that were being used by human underwriters. The computers were being far more liberal in applying rules.

It doesn't mean they were bad loans, just ones that no human underwriter would have thought prudent.  My guess is, however, that the loans that were approved under the more liberal computer rules had a delinquency and foreclosure rate that was no different than the performance of loans that were underwritten under the old, stricter rules. The new rules were just not as strict, but still reality-based.

What happened with the subprime lenders was that they simply threw out the rule books altogether.  The executives and other employees became so addicted to the massive amounts of money they were making, - two, three, four times or more than what ethical lenders were earning on comparable loans – that they just didn't want to quit. They would approve anything!

Reality appears to be finally rearing its ugly head and we're seeing the consequences.

Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower articles. Randy is a mortgage broker who has financed over $1 billion in properties. He writes about home buying and real estate finance topics for CreditBloggers.com.

Comments

[Brandan]

It's important to remember commonsense and have a long-term view. Sometimes the underwriter who does his job is looked down upon or with annoyance, but the underwriters who follow the rules help keep their company in business and help prevent borrowers from being involved in a foreclosure -- something that's good for everyone.