Subprime lenders chose exceptions, money over underwriting guidelines

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This Reuter’s article outlines how the use of "exceptions" have fueled the rise of defaults among subprime borrowers. Exceptions is just a euphemism for "outside of guidelines" where the bank approved a loan even if it didn’t meet underwriting criteria.

Here’s an example. Say I have a subprime loan that has a debt to income (DTI) ratio of 57%. This loan would normally not qualify under the underwriting guidelines of most subprime lenders; that number is usually 55% (which is ridiculous, more later). So instead of killing this loan, my account manager at the bank goes to their superiors and tries to get the "exception" to allow this loan to go through even though it is outside of (already loose) underwriting guidelines.

The account manager would use (thin) compensating factors to argue why the loan should go through and the superior would have to determine if those factors made the loan "safe" enough to allow it to go through. Examples of compensating factors are low loan to value amount or a higher-than-average credit score – whatever they could find as an excuse to approve the loan as an exception.

Most of the time these would go through. These exceptions are what kept subprime mortgage volume high throughout 2005 and 2006. While the article doesn’t give hard numbers on the numbers of exceptions made they most-likely do represent a significant portion of originations – especially in 2005 and 2006.

The panelists conceded that 2006 may go down in history as the worst year ever for subprime credit quality, but said the worst projections for double-digit losses on bonds backed by the collateral won’t materialize.

Hat Tip: Mortgage Lender Implode-O-Meter