The return of subprime lending

Aisha McKnight-Baron couldn’t believe her ears. Turned down by Bank of America for a home mortgage, McKnight-Baron was stunned to learn from her real-estate agent that she could still qualify for a loan. The lender was Angel Oak Home Loans. The company, based in Atlanta, offered a loan program that targeted the millions of people like her with credit problems who, since the 2008 financial crisis, have been unable to secure a traditional mortgage.

For McKnight-Baron, a dispute last year over a loan payment had caused a negative blip on her credit report and axed her out of the mortgage market — or so she thought.

“It was going to take up to 60 days to resolve the issue, and I didn’t want to lose the house,” said McKnight-Baron. “Bank of America wouldn’t give me the loan, but Angel Oak did.”

Thwarted for years by the nation’s banks, which virtually shut down mortgage lending after the financial meltdown, and stricter rules imposed by federal regulators, a growing number of credit-impaired borrowers like McKnight-Baron are again finding their piece of the American dream. Unlike the risky subprime loans from before the financial crisis — many involving no down payment and no documentation — these new subprime loans require minimum down payments of 20 percent and proof that borrowers can pay the monthly mortgage. While investors have taken notice and are pumping billions into the lending institutions making these loans, government regulators, including the Consumer Financial Protection Bureau, say they intend to keep a close eye on lenders, with the hope that the loans don’t morph into the toxic products that were bundled into securities and devastated the nation’s economy.

For McKnight-Baron, a plastic surgeon in Atlanta, the subprime loan was a lifesaver. She received a 30-year loan at a fixed rate of 9 percent, which is more than double the current rate offered for conventional loans but well below the usurious loans widely seen prior to the 2008 mortgage meltdown, in which subprime rates often exceeded 15 percent.

“The rate is a bit higher, but [Angel Oak] considered my circumstances, and I’ll be able to refinance,” said McKnight-Baron, who applied for the loan in October and moved into her new home just before Thanksgiving.

In the years following the financial crisis, access to mortgages has been limited to those with pristine credit. Typically, only those with credit scores well above 700 have qualified for loans backed by Fannie Mae and Freddie Mac, the quasi-government agencies that guarantee more than 90 percent of the nation's mortgages. The largest banks, including Bank of America, Citibank and Wells Fargo, have spent many years and tens of billions of dollars settling claims from investors, government regulators and the U.S. Department of Justice that they knowingly sold toxic subprime loans packaged into securities to investors, causing the financial crisis. Most recently, Bank of America agreed in August to pay $16.65 billion to settle all federal and state claims alleging financial fraud leading up to and during the financial crisis.

Still smarting from the payouts, bad publicity and highly volatile regulatory climate, which resulted in the 2010 Dodd-Frank Act and its slate of new rules regulating the mortgage market, the banks have strongly resisted efforts by the Federal Housing Finance Administration, which oversees Fannie and Freddie, to open up lending to riskier borrowers.

Laurie Goodman, director of housing-finance policy at the Urban Institute, in Washington, D.C., has gone so far as to say that more than 1 million additional loans would have been approved in 2012 alone if lenders had followed standards from 2001, well before the financial crisis. Instead, restrictive lending has created a whole new dynamic in which investors have gobbled up foreclosed homes to rent to people unable to obtain a mortgage. And the restrictive mortgage climate and stagnant home sales have contributed to the tepid economy. 

On Dec. 1, the FHFA lowered the minimum FICO credit scores to 620 and down payment requirement to 3 percent for Fannie- and Freddie-backed loans to first-time buyers in an attempt to prompt the banks to increase their lending. But Bank of America and JPMorgan Chase have already indicated they will not change their lending practices for the foreseeable future. And the new guidelines do not address the borrowers who lost their homes during the crisis to a foreclosure or short sale. Under Fannie and Freddie rules, such borrowers have to wait a minimum of four years before they can apply for a government-backed loan. For Angel Oak, the waiting period is one day.

“It’s such a tight credit box,” says Whitney Fite, the executive who oversees Angel Oak’s mortgage program. “On paper if you have a foreclosure you’re a terrible risk, but it can’t be that way. You have to put some common sense into this and look for areas that banks won’t go. It’s a very underserved area of the market.”

Angel Oak is licensed in 11 states and plans on making its loans available in every state by the end of 2016.

Jason Purcell, a partner in Certified Mortgage Planners in Orlando, Florida, said he has steered a growing number of clients to lenders like Angel Oak over the past six months. But he said that the new programs are centered on credit-impaired customers who still have the wherewithal to pay a substantial down payment of 20 percent or more.

“Right now we’re seeing loans to people who can put a significant amount of cash up front,” said Purcell. “So while it’s opening the market somewhat, it’s still not serving the borrower with limited means.”

But that will likely change as hedge funds, private-equity firms and several foreign banks are betting billions of dollars that the new subprime market will explode in the coming years.

The Japanese bank Nomura, for instance, has provided a $150 million credit line to Angel Oak to fund its mortgage program, while hedge-fund manager MountainView has started a new fund it hopes will eventually raise upwards of $1 billion to finance new loans. MountainView, which is based in Denver, and New Penn Financial of Plymouth Meeting, Pennsylvania, plan to offer 30-year loans with fixed rates ranging from 6 to 9 percent to customers with FICO scores down to 600 and below, depending on their circumstances. And like Angel Oak, which will lend to borrowers with credit scores as low as 500, they’ll initially require a minimum 20 percent down payment, though their waiting period following a foreclosure or short sale is one year.

Aside from reaping the yields from the higher interest mortgages, many of these firms also plan on bundling their loans into securities and selling them to investors, a sensitive proposition given that securities backed by subprime-mortgage loans that were poorly underwritten to borrowers who couldn’t afford them were blamed for creating the financial crisis. Nomura, for instance, plans on using its investment as a stepping-stone to gaining the underwriting assignment for Angel Oak’s debut securitization, which is now planned for sometime next year.

“A lot of investors are interested in the yields and are negotiating arrangements to back loans they are comfortable with,” said Bob Magee, chief investment officer at Shellpoint Mortgage, which is the parent company of New Penn. “It’s just starting and not going to be big right away, but it has the potential to be sizable.”

Even rating agencies Moody’s, S&P and Fitch, which were blamed for looking the other way while stamping triple-A grades on many failed securities, are now taking meetings with lenders about rating the new subprime securitizations. Newer players like Kroll and Morningstar are also eyeing their share of deals.

“We’re seeing a lot of capital being invested in this space,” said Brian Grow, who heads Morningstar’s mortgage-bond-rating group in New York.

The rush of money flooding into the burgeoning subprime market hasn’t gone unnoticed and has already caught the attention of the Consumer Financial Protection Bureau.

Established in 2010 to serve as a consumer watchdog over a wide range of financial instruments, including auto loans, credit cards, student loans and mortgage lending, the CFPB has been closely monitoring these new loan programs, which, according to a spokesman, have not raised any red flags.

“They appear to be following strict underwriting guidelines,” said Sam Gilford, a CFPB spokesman.

But there is concern that lenders will eventually modify the lending criteria once their programs gain traction. In particular, with the financial crisis still a fresh memory, regulators are worried that lenders will begin lowering the minimum down payment to broaden mortgage availability to a wider spectrum of poorer credit customers, including those with fresh bankruptcies.

“We’d be concerned if there was an indication that a lender was not making good loans,” said Gilford. “That’s when we’ll have to closely monitor what’s going on in the market.”

Editor's note: This version of the story includes the full name of the lending organization Angel Oak Home Loans.