To Loan Or Not To Loan: A Subprime Dilemma

A Senior Vice President for a midsized commercial bank is contemplating getting her bank to move forward in extending subprime loans. She has observed her competitors' profits rise following their entry into this market. The two percent lending premium on subprime loans is an attractive addition to bank income. In addition, she wants to help those customers who do not qualify for traditional, prime home loans obtain the American dream of homeownership. With financial advice and counseling, the vice president believes that customers who have low credit ratings due to a few late payments, difficulty in documenting their income, or, perhaps, a prior bankruptcy deserve another chance and given the opportunity to move into their own home. In making recommendations to the bank, the analysis is divided into three parts: a statistical examination of delinquency potential and credit ratings, an examination of aggregate economic implications (with statistical analysis) for the home loan market, and an evaluation of the ethical aspects of lending to subprime customers.

CASE DESCRIPTION

Students face a bank's decision to enter or not enter the subprime home lending market. The situation is set just prior to the problems that arose in 2007-2008. The case provides aggregate economic data available at the end of 2006 and asks students to utilize this data in recommending whether or not to enter this market. The case has a difficulty level of three and is designed for a junior-level course. Including student presentations, the case is covered in three class hours. It is expected that students will spend 3-5 hours outside of class preparing this case.

CASE SYNOPSIS

A Senior Vice President for a midsized commercial bank is contemplating getting her bank to move forward in extending subprime loans. She has observed her competitors' profits rise following their entry into this market. The two percent lending premium on subprime loans is an attractive addition to bank income. In addition, she wants to help those customers who do not qualify for traditional, prime home loans obtain the American dream of homeownership. With financial advice and counseling, the vice president believes that customers who have low credit ratings due to a few late payments, difficulty in documenting their income, or, perhaps, a prior bankruptcy deserve another chance and given the opportunity to move into their own home.

In making recommendations to the bank, the analysis is divided into three parts: a statistical examination of delinquency potential and credit ratings, an examination of aggregate economic implications (with statistical analysis) for the home loan market, and an evaluation of the ethical aspects of lending to subprime customers.

TO LOAN OR NOT TO LOAN: A SURPRIME DILEMMA

Middletown, December 2006

Owning a home is part of the American dream. Having a home creates ties to the community, provides stability, and promotes civic pride. This desire for homeownership is so much a part of the American culture that governments promote this ownership by providing significant tax incentives. Mary Taggert is Senior Vice President for Mortgage Lending at a medium-sized bank, Citywide State, operating in the Midwest. Mary prides herself in her role of helping her customers realize this American dream. She wants to help extend the opportunity of homeownership to her customers who previously would not qualify for a home loan from Citywide by convincing the bank management to enter into the subprime home lending market.

Citywide has been a fairly conservative banking institution, concentrating on commercial lending to local business and low-risk home loans. The home loans extended by Citywide are to prime borrowers. These borrowers have reasonably well-established credit and borrow in loans conforming to Fannie Mae or Freddie Mac criteria. Such loans can be packaged and sold through these government-sponsored agencies. The risk to the bank is low, many of the loans are sold to other institutions and pension funds while the bank earns fees for processing the payments. Prime borrowers generally had credit scores of 640 or higher.

In managing the loan business for her bank, Mary sees her job as dealing with two significant problems. Prior to extending a loan, she must deal with adverse selection. Once the loan is extended she needs to provide sufficient incentives to reduce the moral hazard problem. Adverse selection results from asymmetric information. The potential borrower knows more about their likely behavior and financial condition than the bank. If the bank establishes a lending criterion that is significantly more lenient than its competitors, the borrowers selected are more likely to be higher risk and less likely to maintain their payments. Once the loan is extended the borrowers might expose the bank to unanticipated risk by failing to maintain the property. Mary sees this moral hazard problem is reduced by requiring a minimum down payment of 0 percent of the property ' s value. Since the first party to incur a loss, should the property value decline, is the homeowner, they have an incentive to maintain the value. The adverse selection problem is managed by screening the applicants. A potential borrower's credit score has proven to be a useful screening device.

Mary has been frustrated by having a screening rule that only permits loans to highly qualified borrowers. Since her bank only issues prime mortgage loans, she must turn away business from borrowers with 640 or lower credit scores. She has watched her competitors enter the less than prime (subprime) market with a high degree of success and seen many of the subprime borrowers succeed in making their housing payments, improve their credit scores, and achieve their dream of homeownership. Mary believed that these potential borrowers should not be denied the opportunity of homeownership just because of a few late payments, difficulty in documenting their income, and, perhaps, a prior bankruptcy. If they were given the opportunity and provided financial counseling to help them manage their incomes, they would become good customers for the bank, provide an additional source of bank income, and become more productive members of the community.

The subprime market developed in the late 1990s. These loans were designed to provide potential homeowners with less than perfect credit the opportunity to get back on their feet, improve their credit rating, and ultimately refinance into a prime loan at lower rates. The initial subprime loans required a 20 percent down payment, had a fixed interest rate for the first two years that was generally 2 percent above the prime, 30-year fixed-rate, and moved into an adjustable-rate mortgage (ARM) after two years. Moving into the 2000s, housing prices were rising, equity was being built up for the homeowners and the loans were profitable. With the subprime loans improving bank profitability, banks and mortgage lending institutions moved to make their loans more attractive. The down payment requirements dropped to 10 percent. Institutions, in some cases, would issue loans for 100 percent of the property's value (no down payment). In order to provide additional loans, second loans were sometimes issued to subprime borrowers to permit them to take acquired home equity out of the house. While the latest movement towards more lenient lending criteria has Mary a little worried, she still sees the subprime market as a vehicle to help both her bank, with higher profits and her customers, by providing them with the opportunity of homeownership.

The subprime loans Mary wishes to make would require at least a ten percent down payment, have a fixed rate for two years, including a prepayment penalty during the first two years, and become an adjustable-rate mortgage (ARM) after two years. To compensate for the added risk associated with these loans, the fixed rate would be 2 percent higher than the bank's traditional prime home mortgage loans. The ten percent down would protect the bank in the case of a foreclosure, and the future adjustable rate would make the loan attractive on the developing secondary market for subprime loans. The ARM is indexed relative to the 6-mo LIBOR (London Interbank Offer Rate). Mary is comfortable with these features. She believes that her borrowers would make their mortgage payment, reestablish a higher credit score and be able to refinance after two years into a lower rate prime loan.

Mary has some concerns over entering this market and has hired your consulting firm to help her resolve these concerns and recommend how she should proceed in this market. (Note: This case takes place in December 2006. While you may have future events in this industry available, your recommendations should be made on information available prior to January 2007.)

1. Mary is concerned over how she should use credit ratings in making these loans. She has gathered sample data on credit rating and loan delinquencies which are provided for your use. Loans delinquent beyond 90 days is likely candidates for foreclosure. Mary believes that the bank is willing to accept a minimum credit score that has an expected foreclosure rate often percent.

a. What is the relationship between days delinquent for a given credit score?

b. What credit score is expected to yield average delinquency of 90 days?

c. If Mary used that credit score as a minimum for extending these subprime loans, what proportion of loans to individuals with that score would you expect to be 90 or more days delinquent?

d. Assuming that Mary gets the bank to enter the Subprime market, what minimum credit score would you recommend accepting? Why?

2. Mary is wondering whether or not the success seen by her competitors is the result of recent increases in housing prices. She has heard rumors that the Federal Reserve is likely to tighten Monetary Policy and wonders what the implications are for her success in this market. Mary has provided you with data on historic home price changes in her area along with data on price level (CPI) changes, and interest rates. Using this data, how concerned should Mary be over possible changes in the Federal Reserve policy?

3 . Mary believes that the ten percent required down payment will protect the bank from a loss of principal. However, should the loan default, the funds are likely to be tied up, without interest income for six to nine months. The funds could have been used to fund a prime loan at around six percent interest with a default rate of well under one percent. Mary is wondering whether or not the two percent premium paid on the performing loans will cover the expected loss from the nonperforming loans. She expects a potential default rate of around 3-5 percent. The average home loan is about $200,000.

4. Mary wants to sell some of these subprime loans to the developing secondary market. However, she also wants the bank to retain some in their asset portfolio to add income and make the stockholders happy. She wants an evaluation of the associated risks and a recommendation on whether or not to hold or sell.

5. Finally, Mary is concerned over the potential ethical dilemma over lending substantial amounts of funds to customers who have demonstrated an inability to manage their finances or to not lend to them and deny an opportunity to move forward on homeownership. Is it ethical or not to extend loans in the Subprime market.

In making your recommendations it is suggested that you look into the relationships between changes in-home price, interest rates, and inflation.

QUESTIONS

1. Analyze the extent of adverse selection in the subprime loan market

2. Analyze the extent of moral hazard in the subprime loan market

3. Evaluate the proposed loan product and sale of a percentage of the loan portfolio in their effectiveness of reducing adverse selection and moral hazard in the subprime market.