Will Subprime Bite the Financials Again?

Today I saw an INGDirect ad for adjustable rate mortgages that struck a chord. A week or two ago I read an article at the WSJ Deal Journal Blog that said many of the mega banks were looking at ARM's and subprime again as a way to increase returns. While the article didn't say that the banking giants were getting bank into the fold originating subprime loans, the banks are eyeing the acquisition of "distressed mortgage assets."

I'm not an MBA or finance wiz, but I'm wondering if there aren't practical considerations the big banks are overlooking. We all know that the subprime meltdown was caused by lenders extending too much credit to borrowers that had questionable credit qualifications and with too little equity. The big mortgage lenders have paid a price taking write downs on a good chunk of those loans. Since the number of delinquent borrowers has increased, the risk and corresponding value of the loans has decreased in the secondary market.

If we take it as a fact that home values have decreased (or at least stagnated) due to demand in many areas, the amount of equity that lenders hold has stayed about the stayed about the same (or increased slightly as a percentage). That would normally be fine for lenders because even if they had to forclose on the borrower they would have sufficient collateral. However, there will almost assuredly be a backlash and tightening of lendering standards. This will likely lead to a shrinking pool of qualified buyers and demand sticks lenders with different problems. Reports have quoted Freddie Mac as stating a foreclosure costs it $60,000. While that figure seems misstated to me, banks are undoubtedly better off if foreclosures never happen.

Banks know more about the time value of money than anybody else. The last thing they want to be is in the business of managing real estate. Even if they can find someone to buy the property quickly after a foreclosure, the lender will undoubtedly rack up some fairly significant legal fees in the process of removing the borrower. I'm not sure there is an easy solution, but think that the industry is much more complex than it was in the past. This is compounded by the fact that most big traditional lenders are restricted in the types of investments they can make . Hedge funds and other alternative investment organizations are more flexible and can play both sides of the market.

In the end banks need to shore up their lending standards and re-evalute the risks each borrower poses. Many of the ARM loans already originated have murky credit standards and were securitized into the secondary market with purchasers not exactly sure what they are buying. I hope the banks now moving on the discounted subprime loans have done their research so they won't need to be bailed out down the road after writing down more loans.