Have Banks Been "Giving Tequila to a Drunk"?

Fat portfolios of high-risk subprime loans could spell trouble

Time was, if you missed a few payments on your mortgage, defaulted on a credit card, or declared bankruptcy, most banks wouldn't give you a loan. But lending to consumers with poor credit scores, or subprime lending, has mushroomed over the past decade, with banks doing the bulk of the business. Now, warning signs are flashing that some banks may be getting in over their heads.

On July 27, the Federal Deposit Insurance Corp. seized Superior Bank FSB in Oakbrook Terrace (Ill.) in a bailout that, analysts say, may cost $500 million. Superior, which specialized in subprime loans, failed largely because it overestimated the value of such loans on its books and became insolvent. It's an easy trap to fall into. More than a dozen nonbank-subprime lenders went bankrupt in the late 1990s after they had overvalued their loans.

Banking analysts are growing worried that as the economy slows, Superior will prove to be far from an isolated case. The FDIC says it is closely tracking 150 banks that have sizable subprime portfolios. Critics of the practice say that banks are being irresponsible by lending so much to debt-strapped consumers with a history of not paying their bills. "It's like giving tequila to a drunk," says David W. Tice, president of economic research firm David W. Tice & Associates Inc.

RECORD DEFAULTS. Already, subprime borrowers are having trouble paying back their loans. In June, a record 1-in-10 subprime-mortgage borrowers was in arrears by 60 days or more, according to Moody's Investors Service. More than 6% of all subprime loans are seriously delinquent, meaning they haven't been paid in three months or more, says Mortgage Information Corp., a San Francisco research outfit.

As if that weren't enough, banks may soon be forced to lower the interest rates and fees they can charge on subprime loans, cutting their profit margins. On July 26 and 27, the Senate Banking Committee held hearings on predatory lending to assess the scope of the problem in the subprime market. Committee Chairman Paul S. Sarbanes is among legislators urging measures to cap charges on subprime lending.

The bad news comes at a time when banks have lent more money than ever to consumers with poor credit. Last year, over $160 billion in mortgage loans, the bulk of subprime lending, was advanced to borrowers with imperfect credit, up from $25 billion in 1993, says SMR Research Corp. Consumers with sketchy credit histories took some $100 billion in credit-card and auto loans in 2000. Most of this business is being done by banks, led by the likes of Citigroup (C ), J.P. Morgan Chase (JPM ), and Bank of America (BAC ).

STIFF RATES. Despite record consumer-debt levels and a rising tide of layoff announcements from companies, banks show few signs of curtailing that lending. Indeed, SMR Vice-President George Yacik estimates that subprime-mortgage lending alone will reach $220 billion this year. The attraction for banks is simple: Subprime loans earn more profit, since they carry interest rates as much as 1.5 to 6 percentage points higher than traditional loans. Charge cards for consumers with poor credit histories can carry annual fees as high as $100. The downside is that loss rates are also much higher than on traditional loans. "You can make a lot more money in good times and lose a lot more in bad times," says Richard M. Kovacevitch, CEO of Wells Fargo & Co. (WFC )

So far, the big banks aren't feeling the pinch. Citigroup, by far the largest bank subprime lender, had $58 billion in subprime home and personal loans in second-quarter 2001 through its CitiFinancial subsidiary, up 13% from a year ago. Its credit losses, at 2.52%, are up just barely from a year ago. Chase Manhattan Mortgage Corp., a unit of J.P. Morgan Chase & Co., has been "slowly but steadily" increasing its subprime business since 1995, says Executive Vice-President Luke Hayden. He acknowledges that the softening economy places "greater stress on higher-risk borrowers," but adds that "banks are good at making credit-risk decisions."

Regulators are eager to quell any suggestion that banks should be getting out of subprime lending. "We have no doubt that this is a business that can be done safely, but it's more difficult to do right [than traditional lending]," says Mark Schmidt, associate director of the FDIC's division of supervision. If the economy doesn't start to pick up again soon, it may become painfully obvious who has--and who hasn't--done it right.

By Heather Timmons in New York

    Before it's here, it's on the Bloomberg Terminal.