Subprime Borrowers Face Challenges as Lenders Weigh Risks

In a move that is expected to impact the lending landscape, financial institutions are being urged to exercise caution when dealing with subprime borrowers. These individuals typically have weakened credit histories, marked by payment delinquencies and possibly more severe issues such as charge-offs, judgments, and bankruptcies.

Key Challenges in Subprime Lending

• Weakened credit histories
• Payment delinquencies
• Charge-offs, judgments, and bankruptcies
• Higher risk profiles for lenders

Regulatory Requirements

Financial institutions are expected to develop comprehensive policies and procedures that set limits on the amount of risk assumed and address how they will control portfolio quality. Acceptable origination channels, dealers, brokers, correspondents, and marketing firms should also be included in written policies.

Regulatory Capital Requirements

Minimum regulatory capital requirements will not apply to institutions with portfolios exhibiting higher risk profiles, but lenders are expected to retain additional capital support commensurate with the volume and nature of the risks assumed.

Strong Risk Management Key

Subprime lending should only be conducted within a comprehensive lending program that employs strong risk management practices. This includes:

• Identifying elevated risks
• Measuring and monitoring risks
• Controlling risks through policies and procedures

Regulators are urging lenders to proceed slowly and cautiously when establishing subprime lending programs, citing the importance of planning, strategy, and staff expertise.

Real Estate Lending Concentrations

In particular, regulators are warning against concentrations in real estate loans, which can pose a significant risk to an institution’s capital structure. Adverse economic conditions could result in a decline in realty values, while additional risks include:

• Granting loans without considering normal or depressed property values
• Failure to reasonably restrict loans on properties with limited demand

To mitigate these risks, institutions should adopt policies that address:

• Maximum loan amounts
• Required appraisals
• Limits on residential single-family construction lending
• Guidelines for supporting draw requests

Liquidity Risk Management

In addition to managing credit risk, regulators are emphasizing the importance of liquidity risk management. Institutions should:

• Understand the nature and level of their liquidity risk
• Establish a tolerance for such risk
• Approve significant policies related to liquidity and funds management

Senior management should monitor and control liquidity risk within the parameters of Board-approved policies, while the Chief Financial Officer should manage liquidity risk in consultation with the Board or an authorized Asset Liability Management Committee.