Ten Years Gone, but the Memory Remains
Litigation related to pre-financial crisis subprime mortgage lending and securitization has resulted in a decade-long hangover for many of those who participated in the boom times. The boom actually lasted only four or five years for most participants, but more than a decade later, many are just now drawing closer to resolution of legacy disputes. The lingering headache for lenders, sponsors, trustees and investors explains the caution that has been the hallmark of subprime residential mortgage-backed securities (RMBS) post-financial crisis.
Since subprime lending started its comeback in 2009, loan approval rates have plummeted, but so have risk levels. With the implementation of Dodd-Frank, certain high-risk products and loan attributes are no longer being offered or tolerated, such as zero deposits, negative amortization loans, stated income loans and low teaser rates. The implementation of an ability-to-repay standard in underwriting across the board has changed the subprime industry, leading to increased investor confidence in subprime RMBS and robust growth.
Subprime’s Trajectory May Ultimately Be Outside of Lenders’ Control
Originators of subprime loans this time around are more likely to try to escape the taint of that moniker by rebranding the sector “nonprime,” but whatever the name, its growth should continue based on the positive outlook for the housing market: inventory is expected to remain low as homeowners stay put due to increasing interest rates; low inventory, in turn, should result in higher prices; and higher prices should translate into larger equity and more consumer confidence.
In normal times, the end result would be more spending and more borrowing. In fact, as in past cycles, there is a risk that demand grows until a tipping point is reached, after which competition among lenders for a share of the growing pie creates a race to the bottom in terms of lending standards.
But the new tax law may throw water on any fire in subprime lending before it even gets burning. As a result of the new Republican tax law, borrowers will no longer be able to deduct the interest from their home equity loans and lines of credit (HELOCs) – whether for pre-existing loans or new loans going forward. In a high-cost and high-tax market, more consumers may start turning to unsecured lines of credit instead, hindering the continued growth of the subprime lending market.
They Say History Repeats but Lightning Doesn’t Strike Twice…
The latter isn’t entirely true – with enough time, it actually becomes inevitable. But with the new tax law, coupled with record-high household debt, the looming student loan crisis, risky practices in subprime auto lending and growing consumer debt, including alternative, unsecured forms of credit, it’s likely the subprime RMBS market is not the first place to look for trouble any time soon.
Massimo Giugliano, counsel in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.