It all started last November, when a relatively small lender — called Own-It Mortgage Solutions — defaulted on its loans to JP Morgan Chase & Co. Since then, more than 24 subprime lenders have folded, victims of rising default rates — but also of rising suspicions that the entire subprime market is teetering.
One of the nation's biggest subprime lenders, New Century Financial, is expected to file for bankruptcy any day now.
Like a lot of lenders in the subprime market, New Century specialized in zero-down and no-interest loans, which cater to people with credit problems. For years, the company was able to prosper because of the financial support of much bigger Wall Street banks.
But as the housing market has slowed, and regulations have tightened, that support has quickly dried up.
Subprime lending has long been the forgotten, low-rent corner of the mortgage business, touched by a down-market taint. But the image is deceiving, industry analysts say: Subprime lending is based on the support of Wall Street's old-line banking establishment.
"It encouraged it; it funded it," says Guy Cecala, publisher of the Inside Mortgage Finance newsletter. "Since the mid-90s, warehouse lending by Wall Street firms is what's kept companies like New Century in business."
Cecala says that at one time, companies that were in the mortgage business lent out their own money.
But in the mid-1990s, there was an explosion in mortgage-backed securities. Mortgages could now be repackaged as bond debt and sold to investors. Companies like Countrywide could now market and sell mortgages to their customers.
And that, in turn, led to spreading risk. But it also opened the door to a lack of certainty over borrowers' ability to repay loans that had been pooled together and sold to investors like mutual funds.
"These loans get sliced and diced, securitized and spread to the wind," former Federal Reserve Governor Edward Gramlich says, "and nobody has a clue who the ultimate — they know who the borrower is — but where the money comes from. It's all around the world."
Investors loved the securities, seeing them as a way to invest in mortgages when the housing market was strong. They even loved the risky subprime mortgages that came from customers with weak credit. Big banks like Wells Fargo and Citicorp started their own subprime divisions.
The big banks had another reason to like subprime lending. Keith Ernst of the Center for Responsible Lending says that many subprime companies are state-chartered, which means they aren't highly regulated.
"I certainly think this helped the volume grow as quickly as it did," Ernst says. "And I also think it's part of the reason the quality is not what anyone wishes it would be."
Ernst says that under federal law, banks have to meet certain safety and soundness regulations, so if they go out too far on a limb — by making too many questionable loans, for instance — the regulators will reel them in.
Guy Cecala echoes that view.
"What we're seeing now in the subprime market is, when the Wall Street firms get cool on the subprime market, they just cut the funding," Cecala said. "And the warehouse loans vanish overnight — and that's what puts a company like New Century out of business."
Analysts say that the upshot of the troubles in the subprime loan industry is that there will be fewer companies offering loans to people with weak credit scores — which means home ownership will get a little more elusive for low-income people.
But it should also wash a lot of risk out of the mortgage market, making it ultimately safer and more stable — at least until the next housing boom occurs.
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