Give me your delinquents,
your former bankrupts,
yearning to borrow. . .

Banks are victims of the finite nature of good credit--there is only so much of it to go around. Faced with continuing heavy competition for consumer and residential mortgage credit, banks have found themselves forced into a decision. They must either look for new business in new areas of lending and banking, or they must reach further down into the markets they're already serving. Just how far down they are willing to go depends on their appetite for risk, or their ability to find ways to securitize the higher-risk loans, as is frequently done, to move the risk off their own balance sheet.

As "A" credits--the traditional bankable loans--have become more scarce, a growing number of large banks are targeting riskier credits, "B" and "C" and sometimes even "D" loans. The trend is evident especially in auto lending, home equity lending, and mortgage lending.

Such efforts, also known variously as "subprime" or "nonprime" lending, reflect one of the hotter ideas to come along in banking in recent years.

"This trend demonstrates how concerned larger banks are about their ability to generate loan volume," says Ed Furash, head of consultants Furash and Co., Washington, D.C.

The means of entering this field vary, with some banks acquiring seasoned finance companies, others pouring more resources into existing finance-company units, and still more simply establishing specialized "subprime" lending staffs within existing lending operations.

Are the lenders pioneering their way into the subprime market winning reliable new profits? Or are they venturing too close to the edge at a time when there is concern about consumers' ability to pay?

The lenders say they have set up systems that will handle the added risks of lending on damaged credit. A recent study, covered later, questions that premise. Federal banking regulators, for all their recent talk of "supervision by risk" and "early warning systems," will admit to no recent study of the subprime trend. There aren't good numbers available showing how much subprime business is being done and there is little agreement from bank to bank about what a "B", "C", or "D" looks like.

Subprime auto lending

How much demand is out there for "B" and "C" auto lending? Estimates range between $40 billion and $100 billion, according to Paul Finfer, president and CEO of subprime lender Franklin Acceptance Corp., Greenbelt, Md. He was speaking at a recent Consumer Bankers Association auto finance meeting. While loan-hungry lenders may think that's a juicy new segment, Finfer told the audience that the growth is "generally at the expense of the marketplace you're in." He noted that decreasing overall credit quality, in part due to the plethora of corporate downsizings--and the popularity among better-risk customers of leasing--has been shrinking the pool of "A" loans.

KeyCorp is one bank company that decided to aggressively tap the subprime market. In September 1995 Key completed its acquisition of AutoFinance Group, Inc., a specialist in subprime lending. As an indication of its commitment to the business, Key made A.E. Steinhaus, head of AutoFinance, group executive for its entire auto finance group. Key expanded the old AutoFinance's market by making its services available to the dealer network that had been offering Key's mainline programs. At the time of the acquisition it was estimated that Key would significantly expand its indirect business through the addition of subprime lending. The move was part of a broader Key effort to expand its subprime mortgage, home-equity, and consumer lending.

By summer 1996, according to Steinhaus, growth in subprime lending was on target, albeit slow. Steinhaus expected this. One point that some bankers neglect to consider, he points out, is that dealers typically work with multiple lenders. Some of these lenders may also offer subprime programs--some may even specialize solely in subprime loans and even in loans to the riskiest consumers of all--the "D"s. (Others point out that some dealerships even employ two finance managers, one for prime customers and one for subprime customers.) In all it can take a subprime lender six months to a year to crack a new market, says Steinhaus, and even longer if the lender's organization is itself new.

Perhaps the hardest part of adapting to this new market, says Steinhaus, is getting away from bankerly thinking. "Most banks are strictly 'A' lenders," he explains, "and in a prime portfolio you're fairly sure you're going to get paid at some point." As a result, "A" lenders work with troubled borrowers and give tardy payers some leeway.

Not so with lending to "B"s and below, says Steinhaus. Veteran subprime collectors monitor and remind the borrowers closely, relying on a more up-to-date management information system than banks typically use because delays in information cannot be tolerated when credit quality is thin.

Bottom line, in the words of Steinhaus: "We don't rewrite, we don't extend; you make the payment or you walk." Such tough policies are essential, the veteran subprime lender believes, to making securitization of subprime lending workable.

In other institutions, subprime lending is a matter of reaching further into the market with an existing corporate form. At Barnett Banks, for example, Barnett Dealer Financial Services, Inc., has been extending itself for "C" and "D" borrowers, most typically for used cars, according to Steven LaMore, president and CEO of the subsidiary.

LaMore says bankers who enter this turf must consider more than just collections (for which Barnett maintains a separate subprime staff that is often hired from finance companies). Differences from mainline lending begin as early as the loan decision. For example, he says, lenders must take care not to advance too much money on used cars with these borrowers. Collateral is more important in this business and the lender who puts too much faith in the collateral can be burned later on if collateral becomes the only source of repayment.

Subprime auto lending isn't a business for those who think there are neglected juicy apples ripe for picking by the quick-witted. Lots of lenders are going after this business and this can affect pricing. Robert Barry, chief financial officer of Regional Acceptance, a Greenville, N.C., subprime lender whose acquisition by Southern National Corp., Winston-Salem, is pending, notes that his firm declined to match some of the pricing seen among subprime lenders in past years and watched growth fall. Growth has been trending up of late, he says, since the market itself has gone through some rationalization. Yet other costs, as a matter of course in this market, are typically higher; Barry points out that staffing levels are higher for subprime auto lending and that operating expenses in general are twice those for banks.

Take the matter of payments. Where coupon books are typical for normal loans, monthly invoices --which entail added postage and processing costs--are essential to lending to the subprime borrower, according to John Speaks, vice-president and senior analyst at Moodys Investors Service, N.Y.C.

In the end, much of the auto paper generated in "B" and "C" lending programs winds up being securitized in either private placements or public offerings of asset-backed securities. The market--consisting of hundreds of buyers, most of them institutions--while anxious for this higher-yielding paper, pays for relative quality, even within the world of damaged credit. Quality--and the experience of the lenders providing the loans behind the security--can lead to different pricing on securities, according to Jewelle W. Bickford, managing director at Rothschild, Inc., New York, speaker at a recent industry meeting.

Subprime mortgages

In June, the nation's mortgage business reached a milestone when Norwest Mortgage, Inc., the leading originator, servicer, and wholesaler of residential mortgages, announced a major expansion of Directors Acceptance Corp., a subsidiary that specializes in "B" and "C" mortgage lending. Directors Acceptance was acquired in 1995.

"Our mission is to finance homeownership throughout North America," says Mark Korell, president of Norwest Mortgage's lender and investor services group, when asked why the company made the expansion. To achieve that goal, he continues, Norwest had to find ways to move beyond the world of loans that meet traditional Federal National Mortgage Association/Federal Home Loan Mortgage Corp. guidelines.

Prior to the expansion, Norwest was making between $10 and $12 million a month in "B" and "C" loans, which Korell considers "minimal." "We were still turning away a lot of people we would like to serve," says Korell. The invigorated effort planned through the Directors Acceptance subsidiary will reach as far down as "C-minus," according to Patrick Sheehy, executive vice-president. Norwest Mortgage defines "C-minus" as applicants who have made three to four late payments in the past 12 months.

To Norwest, the difference between its traditional "A" business and its new ground is vast. "'A' paper programs are typically credit-based underwriting programs," says Sheehy, "whereas 'B' and 'C' programs are typically collateral based." As a consequence of the difference, the Directors Acceptance subsidiary will be home to many specialized staffers, according to its new president, Judith Berry. A much-stronger emphasis will be put on appraisals, required downpayments will be higher, and there will be a certain amount of reading between the lines.

"Often, these are what you call 'story loans,'" explains Berry, "where you have to hear out the applicant and then determine if their trouble was a one-time problem or indicative of a history of inability to pay debt." (At least initially, the operation will not use credit scoring.) As in other subprime lending, it's expected Norwest/Directors Acceptance collectors will ride much closer herd on routine payment dates.

Early Directors Acceptance efforts were sold servicing-released, but Norwest plans to set up a specialized servicing unit later this year. Korell estimates that servicing subprime mortgages will cost two to three times what "A" loans require. Such additional costs will drive the higher rates to be charged on the subprime loans, as will secondary market investors' desire for returns 50-200 basis points higher than for "A" credits.

The recent growth of interest in subprime mortgages by lenders of various stripes is the best documented of the various categories of subprime lending. Even in this area, however, the numbers, compiled by the Mortgage Bankers Association of America, at best are "squishy," because they also include second mortgages and home equity lines of credit without a finer breakout. Nevertheless, the broad trend is clear, as shown in the table nearby: A greater portion of residential lending in the last two years has been devoted to "B" and "C" credit.

There are ways into this business that don't require the kind of commitment that Norwest is making. Case in point: Mellon Bank Corp. decided not to book any "B" and "C" credit into its home-loan portfolio. Instead, Mellon accommodates customer demand for subprime mortgages by working with a "B" and "C" investor called Mayfair Securities, Ltd., which buys such loans from Mellon. In similar fashion, Mellon handles subprime demand for indirect auto loans and home equity loans, respectively, by working with finance companies Household International and Commercial Credit Corp. And the Federal Home Loan Mortgage Corp. has been piloting a securitization program in tandem with a private conduit for seller-servicers who use Freddie's Loan Prospector automated underwriting service.

Subprime home equity loans

Subprime lending, as practiced by banks, can be a natural extension of ordinary customer contact, prompted when a prospective borrower just doesn't come up to the core bank's standards, or it can be a completely standalone activity with its own marketing, product development, and the like.

An example of the latter is NationsCredit Consumer Corp., a unit of NationsBank Corp. The consumer operation manages more than $4.5 billion in receivables in the form of subprime personal loans, personal credit lines, auto loans, and home equity loans. Traditionally the operation generated its business through its own network of branches, dealers, and correspondent lenders. A program to encourage referrals from NationsBank offices was recently introduced.

Another strategy is that employed by First Union Home Equity Bank, N.A. "We've kind of become a one-stop shop for all home equity loans," says Rick Kourey, vice-president, wholesale operations. The bank has locations in 35 states and, through centralized marketing, provides home equity loans to 13 more states. Customers whose credit fails to qualify them for the "A" program may be able to receive a home equity loan from the bank's "B" and "C" specialists. Indeed, about 40% of the bank's origination volume consists of "B" and "C" paper.

"We are going to try to grow this side of the business even more," says Kourey, "because we believe that there are a lot of good, paying customers in the subprime segment."

As quickly as possible, First Union Home Equity's "B" and "C" loans are packaged for sale, servicing released, to First Union National Bank of North Carolina's Mortgage Finance Group. ("A" loans, on the other hand, are generally portfolioed.) In turn, the mortgage group passes these loans on to First Union Capital Markets Corp., the parent's investment banking arm, for securitization and sale to the investment markets.

The investment markets' appetite for subprime paper is such that First Union Capital Markets finds that it can readily go to market every four months or so with a package of loans, according to Wes Jones, managing director of the Mortgage Finance Group.

"It has gotten to the point where you don't have to reinvent the wheel each time," says Jones. To bring the "B" and "C" packages up to investment standards, the securities are credit-enhanced both by overcollateralization--stuffing extra paper into the deal--and with bond insurance.

At Pittsburgh's PNC Bank, N.A., another alternative has been used for subprime home equity credit for the last two years. The bank originates the loan on behalf of another lender, having obtained the customer's consent to sell the business.

"We would consider our own 'B' and 'C' program at some point," says Frederick J. Eisenreich, vice-president and manager, product management/consumer loans, "but not in the consumer credit environment we are in today." Eisenreich says there is something to be said for being paid a fee to pass a risk on to someone else.

A dissenter predicts trouble

Much as bank lenders venturing into subprime borrowing say they recognize and have addressed the special challenges of this field, there are others who aren't so sure. In late June the Financial Institutions Group of A.T. Kearney, the Chicago-based management consulting firm, issued a study questioning many of banks' actions in consumer credit--especially the drive for "B" and "C" borrowers.

Tom Neagle, an A.T. Kearney manager involved in the study and a former banker himself, expresses doubts regarding bankers' real ability to "unbank" their minds when addressing the subprime market.

"The urge to impress the bank mentality on an operation is irresistible," says Neagle. "I question whether a bank can really think like a finance company."

Even where banking companies have acquired successful subprime lenders, rather than growing their own operations, Neagle expresses doubt that bank-like thinking can be avoided for long. The true finance-company success formula, says Neagle, requires not only tough and steady collection efforts but also the willingness to make up for inevitable losses by charging all borrowers very high rates--right up to the relevant usury ceiling. That just doesn't go with being a banker, insists Neagle.

Furthermore, Neagle points out that the current round of interest isn't the first time loan-hungry banks have thought to encroach on subprime lenders' turf. In the mortgage arena, for instance, he points out that some bank-owned mortgage banks pursued "B" and "C" credits in the late 1980s. When the recession of the early 1990s hit, he says, some were badly burned. In one case, he recalls, a leading bank-owned mortgage lender fell so far that it has yet to recover anything near its leading status.

Although few people see a recession looming, it was concerns about recession that persuaded the Kearney firm to explore current consumer credit trends, according to Neagle.

The firm's study predicts that "by lowering their credit standards and saturating the market with loans, many banks will be unable to avoid potentially enormous delinquencies and write-offs." The firm estimates that banks involved in subprime lending could see delinquency rates of 10% by the year 2001.

Could securitization, often present in the subprime arena, be a saving grace for the industry if the worst fears are realized? Neagle worries that this will not only not happen, but could actually backfire.

Neagle makes this case. Asset-backed securitization, in spite of its broad proliferation of types, is really a very young field. Furthermore, even mortgage-backed securitization, excluding that by the established quasi-governmental agencies, is comparatively young. How do people really know, asks Neagle, if those deals are really airtight?

The first time the guarantor standing behind an asset-backed or mortgage-backed deal has to kick in big money to make up for underlying credits that have gone bad, "then people will start looking more closely at guarantors," says Neagle. And what happens, then, if a guarantor can't deliver?

"By securitizing 'Bs' and 'Cs'," says Neagle, "we're inviting all that to happen more than ever before."

In its study, the firm suggests that banks consider a four-fold plan when assessing--or reassessing--subprime lending:

1. Decide what sort of lender you really want to be. Do you want to deal in the niche that is subprime?
2. Price, and if possible, reprice, all consumer products in a manner commensurate with the credit risks you have decided to take.
3. Sell off, without recourse, any subprime portfolios for which you have principal risk, before the market for these portfolios deteriorates.
4. Examine your portfolios of mortgage-backed and asset-backed securities for securities collateralized by subprime paper and sell such securities, especially if the indenture specifies anything other than "timely principal and interest" or if you have any doubts whatsoever about the credit quality of the guarantor.
   
   

A matter of definition

The world of lending to less-than-stellar credits lacks some of the clarity newcomers could want. In this article, for instance, the entire field is referred to as "subprime" lending and "B", "C", and "D" credits are not precisely defined. Lenders in different shops put different meanings to the terms.

For example, some lenders differentiate between "subprime" and "nonprime." They use "nonprime" to define anything not traditionally considered bankable but typically the better of the inferior risks, whereas "subprime" refers to the lowest possible loans--what others call "D"s.

At a recent industry meeting sponsored by the Consumer Bankers Association, Paul Finfer, president and CEO of subprime lender Franklin Acceptance Corp., Greenbelt, Md., gave the following definitions for auto financers:

• "B"--typically scores 600-plus under the Fair Isaac system; has some 90-day past dues but is now current. When extended credit, typical delinquencies are 2-5%; repossessions are 2.5-6%; and losses are 1.5-3%.
• "C"--typically scores between 500 and 600 and has had write-offs and judgments. The borrower has made subsequent payments of some or all of the loans. When extended credit, delinquencies are typically 5-10%; repos, 5-20%; and losses, 3-10%.
• "D"--typically scores between 440 and 500 and has chargeoffs and judgments that have not been repaid and has not made payments on these loans. When extended credit, delinquencies are 10-20%; repos, 16-40%; losses, 10-20%.

"This is not a business for the faint of heart," observes Finfer.