To understand what happened, one of the things you need to understand is just what a sub-prime mortgage is (or more accurately was.) The sub-prime mortgage was an integral part of the mortgage landscape since well before I got into the business (in 1983.) It came out of the “Hard Money” portion of the industry, and was typically worked by individuals and companies that excelled in that type of lending. It was never for the faint of heart. People and companies that worked in this arena were a different breed than those of us in the “Prime” mortgage business. It was rare for someone to truly work in both the Prime and Sub-Prime markets. There were several reasons for this.
The Customers: Sub-prime loans are not good loans. They never were, and were not intended to be. They were very expensive, had high rates, and bad terms. They were for people who could not get better loans. They also required a lot of cash or equity (except when the Wall Street idiots were running – I say ruining – our business.) So the basic customer profile for a sub-prime loan was someone with lots of equity or cash for a down payment who was willing to take an ugly loan because that’s all they could get. Because of this profile traditionally these loans comprised about 5% to 15% of the overall mortgage market.
The Investors: There were two prime investor types for these types of loans: Individuals, and Banks who understood this type of lending. The individual usually had a good sum of cash to invest, wanted a very good return, were willing to wait for their money should the loan go bad, understood real estate, and had some understanding of how lending worked. Working with a “Hard Money Broker” they would literally do loans one at a time by weighting the risk and the yield. The Banks were typically small local banks run by people who had a lot of experience in this type of lending and often started by “Hard Money Brokers” who had enough capital or who simply expanded to the point of being able to own a bank. One of the biggest here on the West Coast was Long Beach Bank; the Money Store was a very successful sub-prime lender from the East Coast that eventually expanded nation-wide.
The Guidelines: Individual investors of course had no “guidelines” and pretty-much would do any loan they felt was secure enough if the yield was good enough. The institutional investors (Long Beach Bank, The Money Store, etc.) would set guidelines based on a combination of equity and traditional standards with acceptable variances. Things like stated income, poor credit, mortgage lates, foreclosures and even bankruptcy were considered with higher rates, higher fees, and larger down-payments. The industry rating jargon was usually something like A- to C-. The investor would usually look at a file and tell you that they thought it was a B, maybe a B+ loan and would then tell you what they wanted for documentation. Each instruction was different, and each set its own guidelines, documentation requirements and rating criteria. (Then they wouldn’t follow them if they didn’t like the deal, or if they wanted to make more money on it.)
The Servicing: As I said before, these are not good loans made to poor quality borrowers. Prime loan servicing (loan servicing is basically collecting the payments) typically works on a high volume of loans and is pretty-much paid a servicing fee (+- .5% a year depending on the loan type) to open 12 envelops a year and pass the money along to the appropriate parties. If a loan falls behind there are rules and systems to help the borrowers get caught-up. If it becomes more of a problem, it would be elevated to a senior counselor. Only if all other options were exhausted would it be handed over to a small group of people who were saddled with the unpleasant task of actually foreclosing on the borrowers.
By contract, Hard Money and Sup-Prime loans were usually serviced by individuals, private loan servicing companies or the institutions that created them. They usually had a very simple system: If the loan was 30 days past due, they started foreclosure. If the person caught up that was fine; if they didn’t, the foreclosure would proceed. After the foreclosure they either retained the property – effectively buying it at 50% to 70% of market, or resold the property – almost always at a profit.
The Business Environment: The Sub-Prime industry and the Prime industry had very different personalities. In the Prime business, it was usually a relationship business that relied on customer service and working to serve the customer’s wants and needs. The people that excelled in the sub-prime arena had a different approach – and they needed to. The investors that they work with wanted the best return for their money, and would take their money where they get it. The institutional investors work the same way – getting bait-and-switched was almost part of the game. The customers were just as difficult. For the most part, these are not responsible people. They would lie to you, give you fraudulent documents and take advantage of every opportunity. The people that excelled in this arena learned to be just as hard as those they worked with – or they went broke really fast.
The Profit: This is what attracted Wall Street. Sub-Prime lenders were almost always very profitable. They made a lot of money when they closed loans, they had high rates, and they also made a lot of money when they foreclosed on the borrowers. Many investors would see returns of 20% per year between the profit made when they resold the property, the pre-payment penalties, and the huge loan fees charged up-front.
In summery Sub-Prime lending was a difficult, marginally ethical, hard business that served a small cliental at a very high price. It was fairly specialized and not standardized. However it served a purpose. There was – and still is – a need for hard money and sub-prime lending. The person in foreclosure or bankruptcy sometimes still wants or needs a lending option. These small, unsophisticated, non-standardized lenders served that need. And then it all got screwed-up…