Risks Associated With Sub-Prime Lending, Lending Criteria of Wells Fargo Report

In the developed and developing world, becoming a homeowner is a vital tool that makes an individual create wealth. Apart from the homeowners having access to bank loans, being homeowners command financial security for future prospects. However, in most developed countries especially in the United States and countries in Europe, most people become homeowners from mortgage bank loans.

In the United States, most states have laws guiding the lending policies that forbid individuals with bad credit history to have access to loans, especially mortgage loans. Thus, the inability of people with bad credit to have access to bank loans creates the emergence of sub-prime loans. Sub-prime lending is the loan provided to people with a bad credit history or to relatively risky borrowers. (Temkin, Johnson, and Levy 2002).

The emergence of sub-prime lending is the refusal of the standard lenders or prime lenders to offer mortgage loans to people with failed credit history requirements. (Chomsisengphet and Pennington-Cross 2006, Homes & Community, 2006).

This paper examines the sub-prime lending crisis and the risks involved in the sub-prime market.

The rest of the paper is organised as follows:

First, this study provides research on the origins of the current Sub-prime financial crisis and its impact across the world.

In addition, the research evaluates a lending institution in the United States and provides an evaluation on the lending criteria of the lending institution, the criteria this lending institution uses to access the risks of each category, and rates of different lending categories.

This paper is valuable to policymakers, financial institutions, and potential mortgage borrowers.

Theoretical frameworks

Theories have been established to reveal the current financial instability caused by the sub-prime mortgage market. A theory of financial instability helps to understand the financial turmoil in the past and the current problems. (Minsky, 1992).

In addition, the asymmetric information where a part in the transaction has more information than the other in the financial transaction is also used to discuss this sub-prime mortgage transaction. Williamson (1985).

It should be noted that the recent financial downturn resulting from sub-prime mortgage lending is informed by these theories. Meanwhile, before throwing light on how these theories have linkages to sub-prime mortgage lending, it is essential to gain insight into the history of sub-prime lending. (Barrell and Davis 2008).

Origin of Sub-prime lending

Studies reveal that sub-prime lending is relatively new in the lending policies of most financial institutions. Research conducted by Chomsisengphet and Pennington-Cross (2006) reveals that the evolution of sub-prime lending started gaining national attention in the 1990s. Typically, some factors contributed to the growth of sub-prime lending in the United States. The emergence of laws enhanced the increase of some mortgage institutions to grant loans to people with weaker economic conditions. (Investopedia 2009).

For example, the adoption of the Depository Institutions Deregulatory and Monetary Control Act (DMCA) in 1980 laid the foundation for the adoption of sub-prime lending. This law enhanced the deregulating of loan rates by pre-empting the states’ interest cap. In addition, the Alternative Mortgage Transaction Parity Act (AMTPA) of 1982 allowed financial institutions to charge variable interest rates. (Mortimer, Fischer,1983, Temkin, Johnson, and Levy 2002).

Although, some features of AMTPA make some commentators believe that the law was out of date and there was a need for the formulation of the new law. However, both DIDMCA and AMTPA provided the legal foundations for sub-prime lending. (Federal Reserve 2008)

The Tax Reform Act of 1986 (TRA) provides an opportunity for an increase in the sub-prime market. The passage of TRA provides an opportunity for the increase in market lending because the law prohibits taxpayers to exercise deduction of interest rates on consumer loans. (Temkin, Johnson, and Levy 2002, Hubbard, 1991, Fullerton, Diane Rogers, 1993).

Thus, between 1990 and late 2000, there was substantial growth in the sub-prime lending system. Lenders aggressively market equity mortgages to tap a large pool of potential borrowers, especially the people with household income between $15,000 and $25000. (Temkin, Johnson, and Levy 2002).

However, Rowntree (2006) does not view the promulgations of various laws as the reason for the emergence of the sub-prime market. Rather the author argues that sub-prime lending emerges as a result of recessions that were enveloping in most countries in the 1990s, and this harms the credit ratings of most people. The results of the recession lead the prime lenders to be more cautious in their lending habits in the 1990s. Thus, the refusal of standard lenders to give out mortgage loans to people with poor credit ratings lead to the emergence of sub-prime lenders.

(Squires, 2004, Retsinas and Belsky, 2005).

In the UK, sub-prime lending started to emerge in the mid-1990s, and in the 2000s, there was the availability of high margins with greater lending risks. In 2001, sub-prime lending in the UK was estimated at £6billions, while the sub-prime sector was estimated to reach £13billions. (Rowntree, 2006, Research and Market, 2005).

However, despite the attractiveness of sub-prime lending to people with bad credit ratings and people with income below average, researchers have revealed that sub-prime contains substantial risks to both lenders and mortgage borrows as discussed in the next section.

Risks associated with sub-prime lending

This section provides the overall risks associated with sub-prime lending markets and how it affects the borrowers, the lender, and the whole economy.

The report from World New Digest reveals that sub-prime lending necessitated millions of Americans to become homeowners between 2001 and 2006, and this made the sub-prime loan business to be very attractive. However, starting from 2006, there was a decline in the housing prices in the United States and some other countries in Europe couple with the economic downturn that lead to the problems, which make most Americans fail to honor the payments of the sub-prime mortgage loan. The financial instability in the United States as revealed by the theory of theories of financial instability makes the most sub-prime lender be in the financial downturn. Approximately 50 banks were closed in the United States starting from 2006 as a result of financial instability caused by sub-prime lending. (World News Digest database, 2007, Bhingarde, Khasseria, and Yellavalli 2007, Federal Reserve, 2008).

In 2007, some lenders in the United States began to start dropping sub-prime lending. For example, in 2007, Ferment General Corp decided to stop issuing the sub-prime mortgage loan to the public. Moreover, New Century Financial Corp also filed for bankruptcy, and Country Financial Corp announced the $11.5 billion of financial problems due to sub-prime mortgage problems. (World News Digest database, 2007, CNNMoney, 2007)

Apart from the US, the risks also spread to other countries. For example, in Switzerland, the UBS announced that the in-house hedge fund, which the bank placed on the US mortgage sub-prime markets, has resulted in the loss of US$ 124 million in 2007. In France, the BNP Paribas secured a similar loss. In Germany, the German bank IKB Deutsche Industriebank AG also secures some substantial loss as a result of the sub-prime mortgage loans. (World News Digest database, 2007, Forbes 2007, Marketwatch 2008).

Borrowers also share the risks of high-interest rates charged by the sub-prime lenders. The high-interest rates led most borrowers to start to default on the loan payment because of this economic pr that started in 2006. The problems made many lenders seek oblemfor alternative methods of forcing the borrowers to repay their loans and these have led thousand of Americans to lose their homes. (Bhingarde, Khasseria, and Yellavalli 2007).

Meanwhile, to understand the operation of sub-prime lending in the financial institution, the paper evaluates the lending criteria of a financial institution using the case of Wells Fargo.

Lending criteria of Wells Fargo

Wells Fargo is one of the top financial institutions, and the bank is among the top 10 banks in the United States. Apart from the bank operations, such as savings of funds, Wells Fargo also offers loans to its numerous customers. Apart from personal loans offered by Wells Fargo, the bank also offers Mortgage Loans, Home Equity, and auto finance. (Well Fargo, 2009, Wells Fargo, 2009)

To give out a loan, Wells Fargo uses five criteria to determine to grant the loan.

First, Wells Fargo uses the credit history of a potential borrower to determine if the person is qualified for the loan. The bank evaluates the credit history scores to determine the amount of loan a borrower can be qualified for.

Although, Well Fargo is happy to grant loans to people with perfect credit, however, Wells Fargo also engages in sub-prime lending. The bank offers loans to people with less than perfect credit and people with low credit scores. Wells Fargo offers home equity loans, refinancing opportunities, and options for bill consolidation for people with low credits. However, while lower interest rates are offered to people with perfect credit, the banks offer higher interest rates to people with low credit scores to forestall the risks associated with sub-prime lending. The interests rates paid depend on the years of repayments (See Table 1). Apart from credit scores, Wells Fargo also asks the borrower the collateral such as certificates of deposits, business assets, or inventory for a borrower asking for a secured loan. This is to protect the bank against risks associated with borrowing. (Wells Fargo Financial 2009, Wells Fargo, 2009).

Moreover, Wells Fargo verifies the capacity of a borrower to repay the loan. Wells Fargo checks whether a borrower can convert an asset to cash. (Wells Fargo 2009).

In addition, Wells Fargo checks the character of a borrower. Wells Fargo uses several criteria to determine how a borrower will conduct after offering the loan. Wells Fargo uses some clues, such as the borrower’s credit history, personal references, and discipline to repay pest debts to determine the character of a borrower. (Well Fargo, 2009).

Finally, if a borrower is a business owner, Wells Fargo checks the cash flow of his business as the primary repayment source. These criteria help Wells Fargo to determine if a borrower is qualified for a loan. (Well Fargo, 2009).

Table 1: Lending Rates for a Mortgage loan

Source: Wells Fargo, 2009

Conclusions and Recommendations

Evidence have revealed that sub-prime lending carries substantial risks to many lending institutions, and this has been the major source of economic downturn across the world. Although, it may be part of the primary obligations of a financial institution to offer mortgage loans to people to increase the number of homeowners, and to abide by government policies. Nevertheless, granting loans to people who have records of not paying the former debts and people with a poor credit history are viewed to be unprofessional and the consequences have led to major economic problems across the world.

Nevertheless, the author is offering the following recommendations.

There is a need for banks to operate under sound credit criteria in order to avoid the problems of non-payments by the borrowers. The line of credit of each borrower must be in line with required standard before banks offering loan to borrowers.

In addition, a financial institution must have sufficient information of a borrower in order to establish whether a borrower has sound credit history.

Finally, banks needs to access the risks before granting loan, the banks needs to do proper risk analysis to evaluate the loan that a bank intends to offer. (Basel 2000).

References

1. Barrell, R, and Davis, E, P, (2008), THE EVOLUTION OF THE FINANCIAL CRISIS OF 2007–8, National Institute Economic Review, 206(1), pp5-14.
2. Basel (2000), Principles for the Management of Credit Risk, Basel Committee on Banking Supervision, Bank of International Settlements, Switzerland.
3. Bhingarde, N, G, Khasseria, H, S, and Yellavalli, B, (2007), The Subprime Mortgage Market:Current State and the Road Ahead, BANK ACCOUNTING & FINANCE.
4. Chomsisengphet, S, and Pennington-Cross, A, (2006), The Evolution of the Subprime Mortgage Market, Federal Reserve Bank of St. Louis Review, 88(1), pp. 31-56.
5. CNN Money, (2007), New Century files for Chapter 11 bankruptcy, Web.
6. Federal Reserve (2008), Annual Review of Break and Seasonal Factors for Reserves and the Monetary Base. Web.
7. Federal Reserve, (2008), At the Federal Deposit Insurance Corporation’s Forum on Mortgage Lending for Low and Moderate Income Households, Arlington, Virginia. Web.
8. Forbes (2007), UBS Dragged Down By Subprime Exposure – Forbes.com. Web.
9. Fullerton, D, Rogers, D, L, Who bears the lifetime tax burden? USA, Brookings Institution Press.
10. Homes & Community (2006), Subprime Lending.
11. Hubbard, G, R, (1991), Financial Markets and Financial Crises, USA, University of Chicago Press.
12. Marketwatch (2008), UBS, BNP Paribas report more hits from credit crisis.
13. Minsky, H, P, (1992), The Financial Instability Hypothesis, Working Paper No. 74.
14. Mortimer, H, E, Fischer, L, R, (1983), The Depository Institutions Act of 1982, USA , Practising Law Institute.
15. Rowntree, J, ( 2006), Developments in mortgage lending to higher risk borrowers, Joseph Rowntree Foundation, The Homestead, UK.
16. Investopedia (2009), What is a subprime mortgage. Web.
17. Retsinas, P, N, Belsky, E, S, (2005), Building assets, building credit: creating wealth in low-income communities, USA, Brookings Institution Press.
18. Research and Market, 2005), UK Non-Standard And Sub-Prime Lending 2005: Update Report.
19. Squires, G, D, (2004), Why the poor pay more: how to stop predatory lending, UK, Greenwood Publishing Group.
20. Temkin, T, Johnson, J, E, F, and Levy, D, (2002), SUBPRIME MARKETS, THE ROLE OF
21. GSEs, AND RISK-BASED PRICING, U.S. Department of Housing and Urban Development Office of Policy Development and Research, USA.
22. World News Digest database, (2007), The Subprime Mortgage Crisis, Retrieved 04, 05, 2009 from World News Digest database.
23. Wells Fargo, (2009), Home Equity Loan & Line of Credit Web.
24. Wells Fargo (2009), Home Equity Account Advantage – Solutions to Fit Your Specific Financial Need.
25. Wells Fargo, (2009), Loan and Credit.
26. Well Fargo, (2009), Personal.
27. Wells Fargo, (2009), Today’s Rate.
28. Well Fargo, (2009), Our five Lending Criteria.
29. Wells Fargo Financial (2009), Exploring Loan option.
30. Williamson, O, E, (1985), The Economic of Capitalism, New York, Macmillan Inc.