Recent headlines in the fixed income market have been dominated by the risks associated with subprime mortgage loans. Mortgage lenders typically categorize prospective borrowers as Prime, Alt A (near prime), or Subprime based upon their credit worthiness. The subprime mortgage market is characterized by lending to lower income borrowers with higher levels of debt to income and weaker credit profiles (e.g. lower credit scores). In contrast, prime and Alt A borrowers will typically have a more solid credit history, debt to income ratio, and loan to value ratio (LTV).
What is happening?
Aggressive lending practices and the rise in “affordability” loans in recent years have led to a rapid expansion of the subprime market. This has resulted in a weaker credit profile for recently originated subprime loans which are now coming under increased stress due to declining home prices and payment shock from Adjustable Rate Mortgages (ARMs).
- Delinquency rates on loans originated in 2006 are underperforming compared to prior issuance vintages
- Lower rated subprime credit spreads have widened significantly
- AAA-rated subprime credit spreads have been more resolute
- Many subprime lenders have experienced significant losses and may be sold or forced into bankruptcy
Source: Credit Suisse
Credit Unions Should Not be Afraid of Subprime
The competition for A and B paper is increasing. In some cases credit unions may be making some loans at a rate lower than required to cover overhead When priced properly, subprime can add member value and provide the credit union a high yielding asset. However, knowing how to price subprime is key decision. Each credit union will have different default rates and recovery rates. A well-capitalized credit union could use the following model to help price loans until their actual data can be used.
Sample Pricing Model:
Cost of Funds: 2.46%
“Hurdle” Rate 4.90%
Required ROA 0.85%
Source: WesCorp, NCUA
The strategies in pricing loans are similar to those used in pricing deposits. A key fundamental in any pricing method is to not set your rates based on your competitors. If a competitor wants to lend C/D paper at a rate that far undercuts the market, let them. A credit union’s goal should be in providing members a fair deal while protecting the institution.
If your credit union would like to learn more about the positive aspects of subprime lending join us for The Opportunity in Subprime Lending Is Right Now, a webinar brought to you by Callahan and Associates.