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Risky loan business thrives
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January 14, 1998: 6:35 p.m. ET
People with tarnished credit can get a "subprime" loan -- for a price
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NEW YORK (CNNfn) - You lost your job, defaulted on your mortgage and you figure you'll never get a loan again.
A blemish on your credit history used to destroy your chances of borrowing money, but a booming high-risk loan market offers an alternative -- for a price.
"This (business) has created credit for people who never had it before -- and that creates buying power and jobs," said Bud Ward, a banking analyst at Ernst & Young.
Known as "subprime lending" in the industry, the high-risk loan business is booming.
Most subprime borrowers are people with good credit who suffered a financial crisis: they lost their jobs, had a catastrophic illness or went through a divorce. They've defaulted on a mortgage, amassed suffocating credit-card debt or declared personal bankruptcy.
"Unfortunately there are people who come into that distressed market every day," said Michael Carney, senior vice president at Nationscredit Consumer Corp., an Irving, Texas-based subprime lender with a $10 billion portfolio. "It's the fastest-growing segment in consumer lending."
The high-risk lending market took off about five years ago when widespread financing became available through asset-backed securities, where loans are bundled and sold to an investor.
Companies were seduced by higher fees and rates. And the greater the risk, the higher the price for borrowers.
For example, a regular mortgage rate is roughly 7 percent, while a subprime mortgage rate could be 11 percent, said Mike Diana, a banking analyst at Bear Stearns. For a $100,000 mortgage, that's a difference of $4,000 a year. A prime auto loan rate could be roughly 9 percent, compared with 12 to 22 percent for a subprime auto loan, he added.
Your rates will depend on your "grade," which could be anywhere from "A-" to "D." (An "A" is considered prime).
Another difference is you won't be able to borrow as much. A prime borrower could get a loan for up to 80 percent of the value of his home; a subprime borrower would have to settle for 70 percent.
"The more risk you are, the higher the percentage we charge you," Carney said. "It's to be able to fairly work with consumers at all ends of the spectrum."
Companies will ask you a lot more about your financial background -- and they'll keep much closer tabs on you throughout the life of the loan, said Tom Shippe, senior vice president at Norwest Financial Inc., a Des Moines, Iowa-based lender with a $2 billion loan portfolio.
"We try to watch the customers we finance and their ability to handle payments," he said.
About 30 subprime financing companies went public between 1995 and 1997, raising more than $3 billion, according to the Federal Deposit Insurance Corp., a federal agency overseeing the banking industry.
"Subprime" home and auto loans total roughly $250 billion, the agency said.
And even though there aren't statistics, more banks are getting into the business because of heightened competition in the so-called "prime" lending market, the F.D.I.C. found.
"We see a large amount of business out there and strong competition," Shippe said.
But before you rush to a subprime lending company, keep in mind that some industry watchers aren't sure what lies around the corner.
In testimony before Congress in October, acting F.D.I.C. Chairman Andrew Hove warned that intense competition was forcing lenders to lower their standards too far, opening the door to more defaults.
The F.D.I.C. was concerned enough to issue an advisory in 1997 warning banks about the risks of subprime loans.
Many smaller subprime lenders saw their stock tumble last year, largely because of poor assumptions with loans in accounting statements, Bear Stearns' Diana said.
Shares of Aames Financial Corp. (AAM), have dropped about 70 percent in the last year.
Another lender, Mercury Finance Co., saw its stock battered last year after apparently overstating its earnings. In December, the company reported losses of $27.5 million, or $0.16 per share, for the third quarter ending Sept. 30. It also said it was closing 70 branch offices.
Ernst & Young's Ward pointed out that subprime lending evolved during a robust economy with the lowest unemployment rate in years. But at the same time, bankruptcies are at a record high and consumers are mired in debt. He questioned what will happen if the economy falters.
"We've never gone through an adverse economic cycle with this type of lending," Ward said. "The uncertainty is what happens if we have a significant downturn."
Lastly, don't expect an overnight return to good credit if you do get a subprime loan. It takes three to five years to improve your credit enough for a prime lender to take you seriously again.
"A person can re-establish his credit," Diana said. "Then you can go to a bank and get a loan at prime rates."
-- By staff writer Martine Costello
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