The days of easy money for many consumers with bad credit might be ending.
In a sign that an emerging global credit crunch might soon affect more American consumers, companies that specialize in so-called sub-prime lending to people with blotched credit records--often via high-interest home equity loans--are quickly running out of money as banks and investors cut off their funds.
The result is that many of the consumers who rely on such loans, frequently as a way to consolidate other debts, might be forced to pay even higher interest rates if they can get the money at all.
The sub-prime lenders' woes are a rude awakening for companies that have enjoyed explosive growth--and profits--in recent years. The lenders thrived by pitching their products through mailers that resembled checks and through television ads that feature sports stars such as Miami Dolphins quarterback Dan Marino.
The companies' fierce competition for borrowers fueled a surge in home equity loan originations, which are expected to total $55 billion this year, compared with $7 billion in 1990.
Now, however, the Wall Street funding that provided much of the capital for these loans is drying up, as recent severe losses in foreign financial markets and in the U.S. stock market have caused major banks and brokerages to shrink from risk-taking.
That has already forced some major sub-prime lenders into bankruptcy and decimated the stocks of most others.
"It's reaching fairly cataclysmic proportions," said Michael Sanchez, a portfolio manager at Hotchkis & Wiley, an investment management company in Los Angeles. "In the 11 years I've been in this business, I've never seen anything like it."
The bottom line for consumers likely will be less competition, less loan availability and higher sub-prime rates, analysts said.
"There's going to be a shakeout, and a lot of these lenders are going to disappear," said Reilly Tierney, a special finance company analyst at Fox-Pitt, Kelton in New York.
The effects might be especially acute in California, home of many debt-burdened consumers--and the sub-prime lenders who target them.
More than 2% of Los Angeles County households declared bankruptcy last year, a rate almost double the national average. Richard Pittman, director of counseling for Consumer Credit Counseling Service of Los Angeles, estimates between 2% and 15% of consumers nationwide have bad credit. Many more are burdened with high credit card debts, he said.
Those consumers are the main audience for sub-prime lenders, who specialize in two types of loans: standard home equity loans to people with bad credit, and high loan-to-value lending, which often means extending home equity credit that, when combined with a first mortgage, exceeds a home's value.
Sub-prime lenders make their money by charging higher rates and fees. While a traditional home equity loan to someone with good credit might carry a 9% rate, sub-prime lenders typically charge 11% to 14%, plus up to 10% of the loan amount in additional fees.
Lenders to people with questionable credit have experienced problems before, particularly in the early 1990s, when a recession led to more defaults and delinquencies.
What's unusual about this particular squeeze is that it's not the consumers' fault. While delinquencies on sub-prime loans have increased as lenders reach out to people with poorer and poorer payment histories, the problem so far is with the firms themselves and their sudden inability to get funding.
Sub-prime lenders package most of their loans and sell them as securities to big investors: pension funds, insurance companies and banks who want the juiced-up yields on these higher-risk investments.
The firms rely on banks and brokerages to lend them money to tide them over between the times the loans are made and sold. Until recently, banks and brokers such as Merrill Lynch made tidy profits underwriting new issues of these so-called asset-backed securities.
But now sub-prime lenders are being hit from two directions. Many investors that once bought the securitized loans are backing away amid global financial turmoil, preferring super-safe U.S. Treasury securities instead. At the same time, banks and brokerages are cutting off many of the lenders' lines of credit, fearful of being on the hook to a borrower that might develop financial problems.
"The market's focus has gone from return on capital to return of capital," said Charlotte Chamberlain, an analyst at Jefferies & Co.
A similar flight to quality has affected regular mortgage rates, which increased last week as investors demanded higher returns.
The sub-prime lenders' problems could ease if institutional investors and major banks and brokerages come back to the market soon. But some lenders have already suffered irreparable harm.
Oregon-based Southern Pacific Funding Corp. fell into bankruptcy on Oct. 1. It was followed by Criimi Mae Inc., another major sub-prime lender, on Oct. 5, and by Cityscape Financial Corp. on Oct. 7.