Sunday marks the five-year anniversary of the collapse of Lehman Brothers, the largest Chapter 11 bankruptcy filing in this country's history, triggered in big bets on subprime mortgages that defaulted. And we're still feeling the effects of the crisis that followed, perhaps nowhere more so than the real estate market. Prices in most places still haven't recovered to pre-crisis levels. And subprime mortgages all but vanished. Until recently.
At the beginning of 2007, New Century was the second largest subprime lender in the country, and it needed more office space. So the company signed a pre-lease with The Michelson, an office building still under construction in Irvine, Calif.
"Before the building was even completed, the mortgage market began to crumble and New Century basically went bankrupt," says Andrew White with Jones Lang LaSalle. He's in charge of leasing office space in The Michelson. When the building opened in the midst of the financial crisis, it was so empty you could see through it at night, "and that was the case for a lot of buildings in the area," White says.
"This area" being Orange County, ground zero for the subprime industry. Five years after the crash, office parks in the area are filling back up, but not with mortgage companies. The car company Hyundai now leases the space that New Century wanted.
Among the mortgage companies operated out of Orange County was First Street Financial, ranked among the top 40 subprime lenders in the U.S. "In February 2007, I laid off a good amount of people and shuttered a very successful company that was still making money," says the former head of First Street Financial, Dan Perl. "Why? Because I didn't think the future looked too good."
Today Perl has a much more optimistic vision of the future. He founded a new company called Citadel Servicing, which he says is the first subprime mortgage lender in the U.S. since 2007. Though he doesn't like the term subprime, he prefers non-prime. They are essentially the same.
Subprime mortgages were created for people with less than perfect credit scores who couldn't get loans guaranteed by Fannie Mae and Freddie Mac. But they were aggressively marketed to people who couldn't afford them, with gimmicks like no down payment and no need to verify income. Lenders collected big upfront fees on these loans.
Non-agency prime: Prime mortgages without Fannie Mae/Freddie Mac backing
Subprime: Mortgages issued to borrowers with credit scores of 620 or less
Alt-and Option-ARM: Stated-income mortgages and adjustable-rate mortgages with the options to vary monthly payments
FHA/VA: Mortgages backed by the Federal Housing Administration and Veterans Administration
Perl's non-prime loans go to people with subprime credit. But unlike the old subprime loans there are stricter rules. For one, the income of the borrower has to be verified now.
"We look at everybody's income," says Perl. "We look at their debt in relationship to that income. We look closely the property and if they can qualify under our guidelines even with some credit dings here and there, we will in fact make the loan."
Those credit dings mean that borrowers pay a lot to get a loan from Citadel. Upfront fees can top $10,000. Interest rates start at about 8 percent. But Perl also requires a minimum down payment of 25 percent. So far Perl has raised $200 million to lend. He expects Citadel will have a lot of competition in the next year and a half. "What you are going to find is instead of a $200 million marketplace today, this is going to be a several billion dollar marketplace," Perl says.
Unlike 2006, when anyone with a pulse could get a loan, there are restraints on the growth of the subprime industry. New regulations have tightened credit standards and that means a safer market than the one of the early 2000's. But it also makes it harder for lower-income borrowers to get a mortgage.
"To be blunt, I don't think we want to have a housing market or a mortgage market that favors middle-aged, white rich people. We'd like a market that's more diverse that reflects the population," says Guy Cecala, the publisher of Inside Mortgage Finance.
This, he says, is the great balancing act that regulators have to maneuver. How do you prevent predatory lending and still make loans available to first-time buyers with less than perfect credit?
Henry Pontell doesn't have the answer to that question. But he's been studying financial regulation and white collar crime for decades. He says the ultimate cause of the Lehman collapse was incentives that allowed financial companies' CEO's and managers to make money on loans that were destined to fail.
"We should have learned how perverse environments that encourage heads of firms to take incredibly dangerous risks and sometimes illegal risks is something the government needs to take seriously," says Pontell.
The regulations that were put in place have made subprime lending safer. But Pontell says the bigger problem, the problem of perverse incentives, was not addressed in the regulatory changes enacted after the financial crisis, "and until the government gets it and until policy makers get it and until people get it and demand that changes get made in the law, I would predict that we are going to relive these debacles every 8 to 10 years." And says Pontell, these debacles are not a natural part of the business cycle. It's the way we've structured the financial industry.