Monday, February 25, 2008

A Subprime Legal Question

In my January 28 post I attempted to explain how credit scoring came about in the 1980's and eventually morphed its way to subprime lending twenty years later. In brief, the theory is that you grant credit to a broad group of borrowers with common characteristics and at a higher than normal interest rate. The belief was that in total such a portfolio would produce profits sufficient to cover losses and still yield an above normal return on investment.

The critical element here is that the lender did not attempt to underwrite each individual loan in terms of repayment risk. So, the legal question is, "does this failure to assess individual borrower risk change the lender's position in foreclosure?" To my knowledge this has never been tested in court. We have always had so called hard-money lenders that largely ignored the borrower's ability to repay. But, they protected their position by underwriting the loan against the value of the collateral. In the case of subprime we had lenders not just ignoring the borrowers ability to pay but also advancing 100% and often more than the value of the collateral.

So, could a borrower reasonably take the position that they were reassured by the bank's willingness to advance the money that the bank was satisfied with both their ability to handle the loan and the value of the collateral. I'm quite certain the lender NEVER told the borrower, "hey, we have no clue as to whether you will be able to pay this loan, and if you do not the house will not come close to covering the loan, so you will be left with a big deficiency".


Jeff the Great said...

You know, that brings up a REALLY good point. I wouldn't be surprised if a few lawyers started taking a look at this concept and began seeing dollar signs.

Strip Poker said...

Amusing topic