Subprime Lending Characteristics

By Rex Beach, Shockproof! Training

In retrospect, it seems fairly obvious why so many subprime residential mortgages are in default.

• Underwriters chose not to verify personal income, personal assets, personal liabilities, or personal credit histories. In effect, underwriters chose not to assess debt service ability.

• Underwriters chose to believe rising housing prices represented the ultimate source of debt service, which borrowers readily accepted.

• Underwriters chose to believe in the permanence of a greater fool poised to buy subprime mortgage “assets”.

Fortunately, lenders avoided these credit deficiencies in underwriting business loans over the same period. Or did they? Did the lending exuberance that consumed the residential housing market spill over to other lending fields, such as the small and middle market for business loans? Consider whether the following prevailed or not in underwriting business loans:

• Underwriters chose not to verify business income, business assets, or business liabilities. Instead of requiring compiled or reviewed statements, underwriters readily accepted company-prepared financial statements in view of competitive pressures. Or, as an option, underwriters relied on personal credit histories and mathematical models – credit scoring – to make credit decisions.

• Underwriters chose not to assess debt service ability but, rather, used a simple and time-saving proxy for debt service such as EBITDA or Net Income + Depreciation.

• Underwriters chose to substantiate marginal credits by applying a global cash flow concept in which cash outflows from a business to a guarantor were considered intra-departmental transfers – regardless of the use to which the guarantor put the cash that had clearly left the business.

• Underwriters chose not to verify guarantor financial support or collateral values, turning instead to guarantor-prepared personal financial statements or Quick Books® estimates of business collateral.

• Underwriters chose to believe that abundant credit would be readily available to support future cash flow crises, should crises occur.

Underwriters chose to believe in the permanence of a greater fool poised to buy business loan “assets”.

There is a growing suspicion that many of the excesses and deficiencies displayed in underwriting subprime mortgages carried over to all other markets, including small and middle market business loans. As the economy slows and businesses face rising costs, falling demand, and tightening credit standards, we may well see confirmation or refutation of this thesis over the next several months – especially if the greater fool has gone into hibernation along with AAA credit agency ratings for subprime debt.

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