Saturday, October 14, 2006

How do bankers make money on subprime?

The poster "Tanta" over at the Calculated Risk blog (see sidebar for link) gives an explanation on how mortgage lenders make on subprime loans:

1. Charge big upfront origination fees.

2. Charge big late fees. The most profitable subprime borrower is the one who is always 30 days behind (the "rolling 30").

3. Put borrowers into subprime even though they could qualify for prime credit. (This is called "predatory lending.")

4. Charge very high interest rates.

5. Keep your maximum LTV at 80% or less. That way, you will at least break even on a foreclosure.

It should be said that Tanta is considered to be a resident expert over at one of the most respected (and visited) macroeconomic blogs out there. The problem with contemporary loans, she says, is that the lenders have forgotten about Rule #5.


A poster at Calculated Risk's blog asked how lenders "expect to make money on high foreclosure loans. "

Poster "mort_fin" posted a response (I have edited it for grammar and clarity):

"The math is as follows:

Charge 2 points upfront, then charge a 300 bp spread. Insist on a 5 year prepayment penalty. How much foreclosure will that cover?

Assume that you lose 40% for each loan that goes bad (that's worse than average, which is in the 30's).

Assume that loans that go bad do so, on average, 2 years after origination.

You've made 800 bp in the first 2 years (200 upfront, and 300 a year for 2 years). If 30% of the loans go bad, you make (300 a year for 3 years on 1/2) another 450. That totals 1250 basis points. Foreclosures cost you 30% (loans gone bad) x 40% (loss per loan) or 1200 basis points. With a 30% foreclosure rate you're 50 bp ahead - plus a few of those loans will continue to pay the high spread after year 5 - pure gravy. You can have pretty stiff foreclosure rates and still make a buck -- especially if you can keep your loss per loan down around 30% instead of up around 40%."

In other words, why should lenders care about the customer/consumer if they make money even on bad loans? The whole system sounds predatory to me.

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