and Michelle Conlin
Wells Fargo, the largest U.S. mortgage lender, is tiptoeing back into subprime home loans again.
The bank is looking for opportunities to stem its revenue decline as overall mortgage lending volume plunges. It believes it has worked through enough of its crisis-era mortgage problems, particularly with U.S. home loan agencies, to be comfortable extending credit to some borrowers with higher credit risks.
The small steps from Wells Fargo (WFC) could amount to a big change for the mortgage market. After the subprime mortgage bust brought the banking system to the brink of collapse in the financial crisis, banks have shied away from making home loans to anyone but the safest of consumers.
Any loosening of credit standards could boost housing demand from borrowers who have been forced to sit out the recovery in home prices in the past couple of years, but could also stoke fears that U.S. lenders will make the same mistakes that had triggered the crisis.
So far few other big banks seem poised to follow Wells Fargo's lead, but some smaller companies outside the banking system, such as Citadel Servicing, are already ramping up their subprime lending. To avoid the taint associated with the word "subprime," lenders are calling their loans "another chance mortgages" or "alternative mortgage programs."
And lenders say they are much stricter about the loans than before the crisis, when lending standards were so lax that many borrowers didn't have to provide any proof of income. Borrowers must often make high down payments and provide detailed information about income, work histories and bill payments.
Wells Fargo in recent weeks started targeting customers that can meet strict criteria, including demonstrating their ability to repay the loan and having a documented and reasonable explanation for why their credit scores are subprime.
It is looking at customers with credit scores as low as 600. Its prior limit was 640, which is often seen as the cutoff point between prime and subprime borrowers. U.S. credit scores range from 300 to 850.
Lenders remain cautious in part because of financial reform rules. Under the 2010 Dodd-Frank law, mortgage borrowers must meet eight strict criteria including earning enough income and having relatively low debt. If the borrower doesn't meet those hurdles and later defaults on a mortgage, he or she can sue the lender and argue the loan should never have been made in the first place.
Those kinds of rules have helped build a wall between prime and subprime borrowers. Lenders have been courting consumers who are legally easier to serve, and avoiding those with weaker credit scores and other problems. Subprime borrowers accounted for 0.3 percent of new home loans in October, compared with an average of 29 percent for the 12 months ended February 2004, according to Mark Fleming, the chief economist of CoreLogic (CLGX).
With Wells Fargo looking at loans to borrowers with weaker credit, "we believe the wall has begun to come down," wrote Paul Miller, a bank analyst at FBR Capital Markets, in a research note.
Lenders have an ample incentive to try reaching further down the credit spectrum now. Rising mortgage rates since the middle of last year are expected to reduce total U.S. mortgage lending in 2014 by 36 percent to $1.12 trillion, the Mortgage Bankers Association forecasts, due to a big drop in refinancings.
Some subprime lending can help banks, but it may also help the economy. In September 2012, then Federal Reserve Chairman Ben Bernanke said housing had been the missing piston in the U.S. recovery.
A recent report from think tank the Urban Institute and Moody's Analytics argued that a full recovery in the housing market "will only happen if there is stronger demand from first-time homebuyers. And we will not see the demand needed among this group if access to mortgage credit remains as tight as it is today."
Subprime mortgages were at the center of the financial crisis, but many lenders believe that done with proper controls, the risks can be managed and the business can generate big profits.
Making Up with the Agencies
For Wells Fargo, one of the critical factors in the new strategy was its clearing up of disputes with Fannie Mae and Freddie Mac, said Franklin Codel, Wells Fargo's head of mortgage production in Des Moines, Iowa. The 2013 settlements for $1.3 billion resolved a few battles in a half-decade war between banks and government mortgage agencies over who was responsible for losses from the mortgage crisis.
The bank still has mortgage problems to clear up with the agencies, including a lawsuit linked to the Federal Housing Administration, but Wells Fargo officials believe the worst is over.
Wells Fargo avoided many of the worst loans of the subprime era: It didn't offer option adjustable-rate mortgages, for instance. But when it acquired Wachovia in 2008, the bank inherited a $120 billion portfolio of "Pick-A-Pay" mortgages where borrowers could defer payments on their loans. Those loans have suffered big losses.
One of the reasons for banks being so cautious in mortgage lending now is that Freddie Mac, Fannie Mae and the FHA have been pressing lenders to buy back home loans that went bad after the crisis.
Banks feel that the agencies were using trivial mistakes as a club to pressure banks to buy back loans. But after its settlements, Wells Fargo is more confident about the underwriting flaws the agencies consider material and the quality of the documentation needed to avoid such costly battles.
"As things become clearer and we are more comfortable with our own processes and controls, it gets easier" to extend more credit, Codel said.
Still, Wells Fargo isn't just opening up the spigots. The bank is looking to lend to borrowers with weaker credit, but only if those mortgages can be guaranteed by the FHA, Codel said. Because the loans are backed by the government, Wells Fargo can package them into bonds and sell them to investors.
The funding of the loans is a key difference between Wells Fargo and other lenders: the big bank is packaging them into bonds and selling them to investors, but many of the smaller, nonbank lenders are making mortgages known as "nonqualified loans" that they are often holding on their books.
Citadel Servicing, the country's biggest subprime lender, is trying to change that. It plans to package the loans it has made into bonds and sell them to investors.
Citadel has lent money to people with credit scores as low as 490 -- though they have to pay interest rates above 10 percent, far above the roughly 4.3 percent that prime borrowers pay now.
A Trailer Park in Vegas
As conditions ease, borrowers are taking notice. Gary Goldberg, a 63-year-old automotive detailer, was denied loans to buy a house near Rancho Cucamonga, Calif. Last summer he was forced to move into a trailer park in Las Vegas.
Going from 2,000 square feet to 200 -- along with his wife and two German shepherd dogs -- was tough. He longed to buy a house. But a post-crash bankruptcy of his detailing business had torched his credit, taking his score from the 800s to the 500s.
"There was no way I was going to get a mortgage," said Goldberg. "No bank would touch me."
But in December, he moved into a 1,000-square-foot one-story home for which he paid $205,000. His lender, Premiere Mortgage Lending, didn't care about his bankruptcy or his subprime credit score. That is because Goldberg had a 30 percent down payment and was willing to pay an 8.9 percent interest rate.
To be sure, credit is still only trickling down to subprime borrowers. Jamie Dimon, chief executive of the second-largest U.S. mortgage lender JPMorgan Chase (JPM), said on a conference call last month that he didn't envision a "dramatic expansion" of mortgage credit because of a continued lack of clarity from the government agencies on their repurchase demands.
But smaller, non-bank lenders are making more loans. One such company, ACC Mortgage in Maryland, is offering a "Low Credit Score Debt Consolidation Program" as well as a "Second Chance Purchase Program." Low credit scores don't matter. Neither do bankruptcies, foreclosures or short sales.
"I think that is going to be the wave of the future, basically making non-prime mortgages, carving that out into a profitable niche," said Guy Cecala, publisher of newsletter Inside Mortgage Finance.
"Right now we're at the infant stage."