As the issue of predatory lending captures the media's attention - at its peak, hitting the front page of the New York Times - "subprime" has become the buzzword for evil banking. But from an asset-backed perspective, this negative press could have real implications on home-equity product, depending - for the short term, at least - on the response from investors.
"In terms of the bonds itself, it's possible that [this attention] can hurt the demand, because if investors are worried about having to explain it to their bosses, or whatever, they may be less likely to buy this stuff," said Dan Castro, head of ABS research at Merrill Lynch. "If that's the case, it could mean that it's more expensive for the subprime issuers to issue bonds."
However, there should be no impact on the actual structuring of the bonds, Castro explained. "We all know what subprime is, and that's why we've got structure and credit enhancement," he said.
Of significance, Federal Reserve Board Chairman Alan Greenspan last week announced that a task force had been meeting to address topics, including predatory lending. The announcement followed two weeks of mainstream press coverage, including a feature on ABC News program 20/20.
The danger of the recent coverage, however, is that the media is not making a clear distinction between subprime and predatory lending.
As analysts and industry observers have pointed out, lumping all subprime as "predatory lending" has caused the mainstream perspective to overlook - at worst, potentially threaten - the very base function of subprime lending, which is to provide credit to an underserved segment of society.
"Subprime is not a bad thing, it's a good thing, because you're bringing people who are un-banked to the banking system," said Kevin Mukri, spokesman for the Office of the Comptroller of the Currency.
Referring to the possible regulatory intervention, Owen Carney, president of Bank Capital Markets Consulting said, "If actions have the effect of ending predatory lending, that's good. If they have the effect of limiting access to credit to an otherwise credit-starved borrower, that's bad."
Responding to and/or facilitating the recent press coverage, last week activists from Acorn, the Association of Community Organizations for Reform Now, stormed the Washington-based office of Salomon Smith Barney for the investment bank's association with subprime lender Ameriquest.
Salomon has acted as manager on Ameriquest's securitizations.
However, one investment banker argued, the logic behind raiding the investment bank, from a technical perspective, seems to suggest that the activists don't entirely understand the dynamics of securitization.
"Either that or they're going after [Salomon] because it's the name that gets in the paper," the banker said. "Nobody is going to write stories in the mainstream press about Ameriquest."
Ironically, later that afternoon, Acorn did move on to Greenbelt, Maryland-based Ameriquest, said Chris Saffert, legislative director at Acorn. The incident was less publicized.
"If Ameriquest didn't have connections on Wall Street - where they are getting the money to make these kinds of loans - they wouldn't be able to make them," Saffert said, explaining Acorn's intention with Salomon.
"Granted, predatory lending exists on some scale and needs to be curbed, and needs to be enforced better than it already is," the investment banker added. "But to launch a kind of grand-scale attack on subprime morale, it's probably something akin to swatting a fly with a bazooka. If they apply enough pressure, what are they going to accomplish? Do they want these lenders to shut their doors?"
Acorn, however, maintains that the subprime industry is as much as twice the size it needs to be.
"We would believe there is a place for the subprime industry," Saffert said. "But we think the subprime industry should occupy a smaller niche of the market, and it's putting a lot of borrowers in high-cost loans that should be qualifying for low-cost loans."
There are good arguments on both sides, Castro said.
"I think the basic argument on the one side comes down to, you've got lenders that look like they might be taking advantage of consumers who don't have many options," Castro said. "But you've got people on the other side who say, if you don't provide this money, then they have no access to credit. Are they worse off having no access to credit, or having to pay up for credit that they wouldn't otherwise be able to get?"
The Price of Risk
Aside from the obvious charges of deceit, greed and intentional misrepresentation of the terms of a loan on the lender's part, much of the turmoil associated with predatory lending is associated with the higher rates banks charge when issuing these loans.
How high the risk should be priced - or rather, if the current subprime loan pricing accurately represents the risk - is a topic of debate that could almost stand separate from the other predatory lending concerns, according to several sources.
Subprime borrowers, by definition, are higher risk borrowers with lower credit scores. Add to that the notion that a substantially high percentage of borrowers with subprime scores are minority borrowers, and a political nightmare ensues.
Referring to an incident last fall where government sponsored enterprises Fannie Mae and Freddie Mac were accused of racial profiling, an analyst said, "One of the reasons Fannie and Freddie got in trouble was they were refusing to loan to minorities, on the basis of their [Fair Isaac & Co.] scores, or at least it appeared that way.
"For years the regulators have been encouraging banks to adequately price their risk," the analyst added. "This has to do historically with corporate lending. But now it's turning out that the subprime consumer lending has this heavy minority influence, and if you price it according to the risk, you run the risk of being criticized for predatory lending."
Ironically, as pointed out in PaineWebber's weekly analytical column, the same administration that pushes for the proper pricing of risk also pushes subprime lenders to "lower rates and reduce points, while at the same time, increase lending to the poor and minority borrowers."
Specifically, the FDIC is pushing for a higher capital requirement against the loans, combined with more stringent servicing and underwriting standards when dealing with subprime borrowers, all of which proves more costly to the lenders.
Acorn's point of view, however, is that the loan pricing is deliberately inflated for profits, and a not an accurate representation of risk.
"There is substantial change needed with the overall subprime industry itself," Saffert said. "The cost on the loans a lot of times aren't based on the risk, but instead based on generating the maximum profit for the lender. Subprime lenders are taking advantage of people who feel like they don't have any other options, and who are willing to trust them that they're getting the best rate, when that's not the case."
Saffert cited a study by a government agency where a pool of subprime loans was analyzed. The study showed that there was 100 basis points of interest added on the loans that did not account for risk.
Lenders, and even regulators, argue that the excess cost, in a just environment, represents the cost of additional servicing and more stringent underwriting.
"By and large, I think the banks do a really good job of [pricing risk]," said Mukri of the OCC. "The interest rate is higher, but it's a more costly way of doing business. You have to price different credit histories: injury or illness that has put someone in debt. Prime is easy, because everybody's got a good credit history."
However, Acorn, as well Fannie Mae, maintain that an equally large problem is the "steering": or charging a borrower, who would qualify for a prime rate loan, the high cost of a subprime loan.
"While the subprime lender tells the economically qualified borrower that he has to pay this higher rate because of his credit history, that same lender is often telling Wall Street exactly the opposite," said David Jeffers, vice president of corporate relations at Fannie Mae. "They will explicitly tell investors in those securities, Don't worry, many of these loans that you would think are high credit risk, that you would judge by the rate we're charging them, are really much better loans than that would make it appear.'"