Recent examinations have shown that a number of financial institutions involved in subprime lending have failed to properly assess or control the risks associated with this lending activity. As a result, these institutions are suffering substantial losses that have had a pronounced negative impact on the overall financial condition of some of the institutions. 

Because of the risks associated with subprime lending, institutions engaging in the activity should ensure prudent controls are implemented to mitigate those risks. The following highlights the basic risks presented by subprime lending and outlines some of the general controls believed necessary to manage those risks effectively. 

Subprime lending is defined as extending consumer credit to individuals with incomplete or somewhat tarnished credit records who often are unable to obtain traditional financing. The press and the financial industry refer to these loans as “subprime” or marginal credits. Although credit scoring models vary within the financial services industry, and results provided by common models are inconsistently applied, these consumers generally score below thresholds established for traditional bank credit. 

Subprime lending has become increasingly popular, partially in response to a growing general demand for consumer credit including credit cards, automobile financing, and home equity loans. Bank involvement in subprime lending varies, but generally includes:

• Lending directly to subprime borrowers,
• Purchasing subprime dealer paper or loans acquired through brokers,
• Lending directly to financing companies involved in subprime lending,
• Participating in loan syndications providing credit to such financing companies, and
• Acquiring asset-backed securities issued by these financing companies.

Lenders are primarily attracted to the subprime market segment because of the relatively high loan yields and servicing-fee income typically associated with these credits. However, this profit potential is accompanied by significant risks. Foremost among the risks is a greater likelihood for defaulted loans and any attendant losses.

Effective subprime lenders appropriately stratify the additional default risk inherent in these loans and price the product accordingly. Lenders encounter trouble when their credit scoring models or other loan selection methods produce unreliable or erroneous results, and they are unable to quantify or differentiate between relative risk levels accurately. As a result, these lenders are not appropriately compensated for the assumed risks, and losses exceed expectations. To address this problem, credit scoring models should continually be tested and evaluated to ensure that actual performance approximates initial projections.

Banks engaging in subprime lending should ensure that management expertise is commensurate with this specialized activity and that required operational controls are properly established. Board lending policies should detail the nature and extent of the bank’s permissible subprime lending involvement, including limits on the maximum volume of subprime credits. When evaluating staffing needs, banks should consider the likely demands presented by an increasing volume of delinquent credits and the potential for additional consumer compliance risk relating to these credits.

If loans are purchased from a dealer or loan broker, banks must know the lending criteria used by the originating entity, the nature of service agreements and warranty contracts, and any other relevant items concerning the transactions. Banks should monitor the repayment performance and loss history experienced on individual loans and loan pools purchased from individual dealers. This information should be factored into future purchase decisions and management’s analysis of the allowance for loan and lease losses.

Banks extending lines of credit to financing companies engaged in subprime lending should carefully evaluate the financial information provided by these companies. Rapid growth rates and accounting rules allowing the immediate recognition of non-cash income (interest spread differentials and servicing fees) are among the issues that can complicate the analysis of financial information on firms engaged in this type of consumer lending.

As with any activity, banks should identify and understand the associated risks, design and implement effective corresponding controls, and establish prudent limits before engaging in subprime-related lending or investing. We encourage management to be realistic when projecting future loss expectations and when budgeting for the increased servicing costs associated with subprime credits. Because of the relatively high default and loss rates associated with subprime credits, this lending activity warrants particular caution and management attention.

For more information, please contact your Division of Supervision regional office.

Nicholas J. Ketcha Jr.

Director

Distribution

FDIC-Supervised Banks (Commercial and Savings)

Note

Paper copies of FDIC financial institution letters may be obtained through the FDIC’s Public Information Center, 801 17th Street, N.W., Room 100, Washington, D.C. 20434 (800- 276-6003 or (703) 562-2200).