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The search for capital to fuel the industry has sparked some 25 recent initial public stock offerings, many in the past year. Shares in a number of the newly public mortgage and auto-finance companies are up astronomically: Southern Pacific Funding is up 82%, Cityscape Financial has risen 288%, and RAC Financial Group Inc. has appreciated 300%. All of them have launched ipos within the past 12 months. Another shot in the arm has come from major Wall Street underwriters, including Lehman Bros., Alex Brown & Sons and Merrill Lynch, which buy and bundle sub-prime loans, selling them off to investors as asset-backed (mobile homes, for example) securities. The transactions help get risk off lenders' books, as proceeds are plowed back into new loans, and the cycle starts anew.
How is it possible to make so much money handing out billions of dollars to people who are less likely than others to hand it back? Easy: charge a lot more to compensate for the extra risk. Depending on his or her credit rating, a sub-prime customer will often pay between a third and a half more in interest than a more credit-worthy borrower.
On a 30-year mortgage, a sub-prime borrower pays 11% to 15% interest, in contrast to the 7.75% that banks charge their better-risk customers. On a $50,000 loan, that amounts to $118 to $234 in added monthly payments. Often there are extras such as points, which in the sub-prime market can be a charge of up to 7% of the loan value, not to mention the hefty fees that are demanded by brokers. Throw in ostensibly optional insurance to cover debtors in the event of disability, loss of life or unemployment, and the total interest costs can double. Despite these drawbacks, customers rarely balk because they have few alternatives outside of pawnshops, rent-to-own stores, check-cashing chains or guys with ominous nicknames.
Indeed, the sub-prime loan pool often resembles a vast ocean at the dawn of commercial fishing. Among the easiest borrowers to hook are the 20 million to 30 million people, including immigrants, who have no bank account or credit history. They often can't get the time of day from bank lenders, who have had to tighten standards in the wake of the savings-and-loan scandals of the 1980s and must conform to strict credit criteria if they want to resell their loans to government agencies like Fannie Mae (Federal National Mortgage Association).
The past decade has produced an increasing number of consumers who have scraped their bottom on one of the economy's speed bumps. Included are the more than 6 million people who have filed for personal bankruptcy so far in the '90s. Says J. Terrell Brown, CEO of United Cos. Financial Corp., a big sub-prime mortgage company in Baton Rouge, Louisiana, that reported record earnings last week: "Company downsizings, stagnating incomes, death, disability, rolling recessions, divorce--we want to bridge folks through financial hard times and lend based on their credit future, not their past." United, which first sold shares to the public in 1971, was founded right after World War II and specialized in making loans to soldiers returning home.