The secret has long been out of the bag that if your firm desires strong profits (and have a stomach for risk) subprime is your game. Mortgage bankers of all different stripes — banks, thrifts, non-depositories, REITs —funded a record $608 billion in residential subprime loans last year, a stunning 55% increase in production. In 2005 the industry is on track to fund a second best ever $540 billion in subprime.

The gains in 2004 came while the overall residential loan market — prime, government, jumbo, and non-conforming — declined by about 28% to $2.79 trillion. According to figures compiled by National Mortgage News for this book, subprime production accounted for 21.8% of all residential production last year, the largest market share reading since NMN began collecting production figures ten years ago.

It is not exactly clear why subprime boomed in 2004 and 2005 while the overall market declined but mortgage executives and investment bankers believe there could be several explanations, including increased liquidity brought to the market by the presence of so many Wall Street financiers and conduits.

Also, some believe the recession that started earlier in the decade increased the number of potential subprime borrowers who were able to tap home equity that didn't exist a few years ago. But the biggest reason subprime boomed and bloomed may have nothing to do with subprime at all. It's a fact that many subprime firms — Ameriquest/Argent, Countrywide, First Franklin, MILA, New Century, take your pick — are now key players in the "interest-only," "payment-option," and "Alternative-A" markets.

In researching this edition of the MID we found that quite a few subprime firms are including these products in the production numbers they report to us even though the FICO scores on these loans aren't really subprime at all. Stated differently: over the past two years the distinction between alt-A and subprime loans has blurred — as has the securities market that caters to these respective niches.

Subprime firms are venturing out into other non-conforming niches, including jumbo, because that's where the money is. Subprime lenders, in particular publicly-traded firms, need to keep their production volumes up and one way to accomplish that task is to add new products. Part of the reason these lenders have been successful is that Fannie Mae and Freddie are still struggling to rectify their respective accounting problems and have been slow to create new products. While Fannie and Freddie dig their way out of their accounting and systems problems the non-GSE market (including Wall Street) has filled the void by creating and promoting new loan products such as the IO and payment option loan.

Profit Margins in Particular

As this book went to press there were a number of new studies being released that addressed subprime lending and the profit margin issue. The Mortgage Bankers Association found that subprime lenders have been able to weather tightening profit margins in the mortgage market better than prime lenders over the past several years, despite persistently higher production costs.


MBA's study found that pre-tax production margins of the subprime companies involved in the study fell by 27% to 119 basis points between 2003 and 2004. But over the same time period, prime lenders' margins decreased by 74%. In dollar terms subprime lenders' margins tumbled to $1,806 per loan in 2004 compared to $3,807 in 2002. However they still remain significantly higher than margins for prime lenders, which stood at $435 per loan in 2004.

Subprime lenders that participated in the study experienced significant growth in net servicing margins over the past two years. Beginning with an uninspiring $32 per loan in 2001, subprime lenders' servicing margins actually fell into negative territory in 2002 (with loans posting an average annual loss of $13). But as the refinancing boom persisted in 2003, servicing margins climbed to $155 per loan and continued growing in the following year, reaching $173. The MBA study — which included a sample of 17 subprime lenders and nearly 50 prime lenders — found that in 2004, subprime lenders continued to have significantly higher costs of production than prime lenders. However, among loans originated by mortgage brokers, origination costs for subprime and prime loans were virtually identical, at $158 and $156 per loan, respectively.

In the Spring of 2005 Mercer Oliver Wyman, an international consulting firm, released a study finding that while nonconforming and home equity loans account for less than half of mortgage lending volume, they generate 85% of the industry's profits from loan origination and servicing.

The Outlook for 2005/2006

And now for the bad news: subprime/nonprime has become so "hot" that everyone and their brother has jumped into the pool. As we noted earlier, it's not just subprime anymore — it's IOs, payment option loans, alt-A (there's even a category called ‘Alt-B’) and who knows what variation on these product types is lurking in lenders' laboratories.

The nonconforming market has become a bit frothy and profit margins were under stress in mid-2005. One factor hurting the market is the yield curve (which may become inverted) and the declining yield on the 10-year Treasury which mortgages are pegged to. It boils down to this: the spread between the loan yield and a lender's cost of funds is shrinking and that's not good.

Another development to watch is the evolution of the IO and payment option loan market. The general media has finally found a story in these loans, airing and writing negative pieces about them. It's true that speculators are using these products to play real estate roulette in hot housing markets, including vacation and second homes. But are these loans the 'Twin Satans' of mortgage finance? The jury is still out. And the media has a tendency to blow things out of proportion. Many lenders we've talked to are comfortable funding the products and believe they get consumers into homes in tight housing markets. Is that necessarily a bad thing? Probably not, but the fact that a consumer can't build equity using these loans is a negative. Lenders should be cautious and not overzealous in marketing these mortgages.

As for 2005 and 2006, the outlook for the industry is decent to good, but an eventual slowdown is inevitable, the big questions being: when, and how much consolidation will it bring? In this chapter we rank the nation's top subprime funders. The figures were culled from NMN's exclusive surveys. Some subprime firms, including the nation's largest Ameriquest/Argent, would not provide origination and servicing figures. In some cases we made estimates based on prior surveys filed with us. We also used publicly available information such as SEC documents, analyst reports, or news stories. If you know of any firms that need to be surveyed or if you yourself work for such a lender please contact us. — Paul.Muolo@SourceMedia.com.