The Subprime Lending Crisis: What Does It Mean to the Leasing Industry?

The news is full of stories about the substantial, long-term effects of the subprime mortgage crisis on the mortgage-lending industry. But little has been written about how it will affect other market segments like the leasing industry. There will certainly be spillover, although it won't be as dramatic. This article explores what the leasing industry should be looking for, and doing, in response to this crisis.

The Roots of Today's Subprime Crisis

It wasn't so long ago that home buyers needed 20% down for a mortgage. At
best, it was 10%. Mortgages were pretty straightforward. In fact, the most exotic loans available to ordinary people were for adjustable rate mortgages. In those
days, lenders were mainly brick-and-mortar banks that would probably expect to hold mortgages in their own portfolio for the long term. Today, those days appear positively quaint.

The last decade has witnessed huge changes in the mortgage industry. There are several developments that have played a major role in getting us where we are today. One could debate which development, if any, was the primary mover that led to today's state of affairs. But one thing is clear: If we follow the money, we'll get some important clues.

Let's start with collateralized mortgage obligations ' CMOs ' which is packaging and selling loans as an investment vehicle. CMOs are hardly new, but they became a lot more popular in the last decade or so. The growth in the CMO market led to a surge in demand for mortgages as investment vehicles. As banks found it easier to sell their mortgages, they naturally began to loosen their credit policies. This, combined with historically low interest rates, led to mass refinancings, and even serial refinancings. No longer was a mortgage a one-time affair, religiously paid off until the mortgage-burning party. Instead, people began to refinance regularly.

As the mortgage market expanded, nontraditional lenders began to pop up all over. The Internet made it easy. You hardly needed an office ' just a web site. Automated loan underwriting software eliminated the need for a trained underwriting staff. Lenders competed to see who could approve a loan the fastest. No more did borrowers have to wait days or weeks to qualify. They had their answer in minutes. Lenders didn't even need much capital. All they had to do was find a borrower, issue a commitment, and then shop for an investor to fund the loan before it closed. The 'just-in-time' inventory concept moved into the mortgage industry.

But with all these lenders and all these investors chasing borrowers, the existing pool of homeowners just wasn't big enough. Lenders started looking for ways to give more money to more people. This is where new lending programs came into play. Lenders asked themselves why they had to limit themselves to borrowers who could put 10% down. Loans were made for 95%, then 100% ' sometimes even more. But that wasn't enough. Because increasing the loan amount made the monthly payments unaffordable, lenders started the popularization of interest-only loans, reverse-amortization loans, and the like. Bad credit? 'No problem,' said the lenders. 'We'll just add some points and increase the interest rate to cover the extra risk, and make the loan.'

Because lenders were making so much money selling loans, and because there were so many lenders seeking borrowers, the business became all about origination. It became a matter of qualifying someone for a loan, any loan, by any means possible. Lenders didn't worry about what would happen when the adjustable rate reset in a couple of years, because someone else would own the loan by then. Besides, with all the refinancing, the chances that a loan made today would still exist in a few years were pretty slim. As long as rates stayed low, and housing prices increased, refinancing was inevitable. So a borrower could stay on an introductory, interest-only or reverse-amortization rate forever, lenders reasoned.

That brings us to housing prices. The increased supply of mortgage loans, and the decrease in their initial cost, caused more people to buy houses for the first time. This decade saw record home ownership rates. As demand for houses increased, prices increased. Speculators came hard and heavy, fueled by cheap credit. People flipped their houses like playing cards. This meant more mortgage origination, more refinances, and more money.

Investors liked the 'exotic' ' i.e., risky ' loans because the returns were higher. This, naturally, incentivized lenders to concentrate on those risky or subprime markets.

Oh, and let's not forget the fraud. It's only natural that the competition's making of legitimate, albeit risky, loans led originators to take shortcuts. One could write a book on the schemes invented by lenders, borrowers, and intermediaries, and still scratch only the surface.

Everything fed off everything else, leading us right to where we are today. Default rates are at historic levels. Entire neighborhoods are being threatened with foreclosures. Mortgage lenders are failing left and right.

There's no question that these two factors will play a significant role in ensuring that governments, at all levels, will be doing something about the mortgage crisis. With the media keeping the issue on the front page, it will be impossible to avoid investigation, regulation, and legislation.

How Does This Affect Me?

In several respects, the leasing industry is far different than the mortgage industry. For one thing, nothing that is leased carries the emotional weight of a home. For another, the leasing industry's primary customers are businesses, rather than consumers. But that doesn't mean the leasing industry will be immune from the effects of the subprime fiasco. The mortgage crisis will certainly have ripple effects on this industry. It also should be a cause for introspection on whether it would be beneficial to implement changes in leasing practices.

Where's the Money?

Ultimately, it's all about the money. The carnage in the CMO industry may cause capital to run from debt. Stung by the vagaries of buying pools of secured obligations, investors might be less willing to invest in lease obligations. A smaller, more-skeptical market will mean a higher cost of capital, fewer leases, and less profit.

On the other hand, capital could run from CMOs right into lease pools. When the stock market declined earlier in the decade, investors began to buy commercial real estate in a big way. Buildings began selling at multiples that were impossible to justify ' unless, of course, you were betting on someone buying you out in a couple of years. The same might happen with leases because investors have to put their cash somewhere.

Give Me My Money

The flip side of raising capital is, of course, collecting the money you are owed. It's no secret that this industry is heavily dependent on the financial situation of its customers. Those in the heavy-equipment leasing business have to anticipate the effects of a stagnating or deflating housing market. For example, Lennar Corp., a major home builder, recently withdrew its 2007 earnings goal, after its profits fell more than 73% in the three months ending February.

A bad market will mean less construction, which will mean less demand for equipment. It will likely mean increased defaults on existing leases, as companies that were too thinly capitalized find themselves unable to meet their obligations. Defaults will lead to repossessions. So leasing companies will have used equipment on their hands that they need to dispose of exactly at the time when demand for the equipment will be dropping.

Underwriting

On a longer term, I firmly believe that we are experiencing a sea change ' a tipping point, to use the popular phrase ' in the public's perception of borrowing. It used to be that pre-qualifying for a mortgage was the sine qua non of having good credit. If a bank was willing to qualify you for a loan, you knew you were in sound financial health. You could finance your house, your car, or your boat knowing that you could afford it.

That particular notion may be fading away. Lenders may no longer be seen as gatekeepers, ensuring that only the worthy are allowed through the gates to the Land of Credit. Instead, they will increasingly be viewed as enablers, pushing debt on unsuspecting or addicted marks. You can see this happening already in the credit card industry.

Credit of any kind may become a controlled substance. Certainly, there will be increased regulation of all aspects of the credit industry. Underwriting standards will be tightened. Required disclosures will increase. Government will act in various and sundry ways to put checkpoints on the path to borrowing or leasing.

Moreover, borrowers, courts, and juries may become more willing to fault predatory lenders or take notice of lender liability lurking in the depths of a defaulted loan or lease. To be sure, predatory lending and lender liability are not new. But a larger segment of the public is going to see a default as the result of a greedy or unscrupulous lender rather than a foolish borrower.

Leasing companies need to start preparing for this new reality today. Underwriting needs to be tightened. If you don't have guidelines, you need to adopt them. If you have them, you need to make sure they are followed. If you gather information about the borrower, you should incorporate it into your underwriting decision. If you rely on information, you should take reasonable steps to ensure that it is accurate. What you need to prepare for is the worst-case scenario. How will your underwriting decisions appear to the outside when a business accuses you of predatory leasing practices? Will you be able to demonstrate that you had a reasonable basis to believe that the lessee could perform its obligations, or will it appear that the lease was signed with a blind eye to a likely future default?

The goal of 21st century underwriting cannot be 'How do I protect myself against risk of default?' It will have to be 'How can I minimize and balance the risks of this transaction for all parties?' There is no question that borrowers in the mortgage industry are going to be pursuing lenders for transactions that were arguably unsound or predatory. Institutionalizing sound, justifiable underwriting practices will help guard against similar claims in the leasing industry.

Workouts

The due diligence and care required in sound underwriting does not end when the lease is made. If and when a lessee falls behind, how will you respond? Your lease will provide all manner of remedies that you can exercise, but should you jump right to the most draconian? Of course, few lessors will repossess equipment when a lessee who is honest and straightforward experiences a short-term cash-flow crunch, but you need to institutionalize a workout process. You can be damned if you do and damned if you don't. Propose a reduction in monthly payments and an extension of the lease term, and you can be criticized (and sued) for allowing the customer to dig a deeper hole than he or she already was in. Pull the plug, and you can be criticized (and sued) for killing off a business that could have recovered.

In today's climate, any aggressive action by lenders or lessors is at risk of being second-guessed. You can't eliminate this risk, but you can act
to ensure that, when the second-guessing happens, the path you
took will be seen as a reasoned and reasonable one, taken after considering most, if not all, of the potential ramifications.

One effective way of minimizing the risks of a workout is to enter into a formal standstill or 'pre-workout' agreement. In exchange for some concessions (either temporary or permanent) on your part, you may ask the lessee to agree to certain terms. These might include an express representation that you are not waiving rights by making workout proposals; the lessee's acknowledgment that your lease agreements are valid contracts and that you can exercise your rights under them; or a waiver of any claim that you are liable for any action you take in a future workout that was authorized by your lease documents.

You can also outsource the workouts. Sell the defaulted obligations to another entity that will do the heavy lifting and bear any liability for alleged overreaching. Lenders don't typically want to be in the collection business anyway. It's much more profitable to initiate the transactions than it is to collect. There is little question that the market for troubled credit will be booming in the near-term. Of course, everyone will be looking for bargains, but what else is new?

Conclusion

Though it is easy to dismiss the subprime lending crisis as a far-off storm that won't affect the equipment leasing world, it would be a mistake to do so. There are lessons to be learned from the tumult happening at that end of the credit market. As always, the people who learn the most, and the quickest, from the problems of others will outstrip their competition.

Patrick W. Begos is a partner in Begos, Horgan & Brown, with offices in Westport, CT and Bronxville, NY. The firm engages in business, financial, and insurance-related litigation, trials, and appeals in state and federal courts in New York
and Connecticut, as well as arbitrations. For more information visit http://www.begoshorgan.com/.

The news is full of stories about the substantial, long-term effects of the subprime mortgage crisis on the mortgage-lending industry. But little has been written about how it will affect other market segments like the leasing industry. There will certainly be spillover, although it won't be as dramatic. This article explores what the leasing industry should be looking for, and doing, in response to this crisis.

The Roots of Today's Subprime Crisis

It wasn't so long ago that home buyers needed 20% down for a mortgage. At
best, it was 10%. Mortgages were pretty straightforward. In fact, the most exotic loans available to ordinary people were for adjustable rate mortgages. In those
days, lenders were mainly brick-and-mortar banks that would probably expect to hold mortgages in their own portfolio for the long term. Today, those days appear positively quaint.

The last decade has witnessed huge changes in the mortgage industry. There are several developments that have played a major role in getting us where we are today. One could debate which development, if any, was the primary mover that led to today's state of affairs. But one thing is clear: If we follow the money, we'll get some important clues.

Let's start with collateralized mortgage obligations ' CMOs ' which is packaging and selling loans as an investment vehicle. CMOs are hardly new, but they became a lot more popular in the last decade or so. The growth in the CMO market led to a surge in demand for mortgages as investment vehicles. As banks found it easier to sell their mortgages, they naturally began to loosen their credit policies. This, combined with historically low interest rates, led to mass refinancings, and even serial refinancings. No longer was a mortgage a one-time affair, religiously paid off until the mortgage-burning party. Instead, people began to refinance regularly.

As the mortgage market expanded, nontraditional lenders began to pop up all over. The Internet made it easy. You hardly needed an office ' just a web site. Automated loan underwriting software eliminated the need for a trained underwriting staff. Lenders competed to see who could approve a loan the fastest. No more did borrowers have to wait days or weeks to qualify. They had their answer in minutes. Lenders didn't even need much capital. All they had to do was find a borrower, issue a commitment, and then shop for an investor to fund the loan before it closed. The 'just-in-time' inventory concept moved into the mortgage industry.

But with all these lenders and all these investors chasing borrowers, the existing pool of homeowners just wasn't big enough. Lenders started looking for ways to give more money to more people. This is where new lending programs came into play. Lenders asked themselves why they had to limit themselves to borrowers who could put 10% down. Loans were made for 95%, then 100% ' sometimes even more. But that wasn't enough. Because increasing the loan amount made the monthly payments unaffordable, lenders started the popularization of interest-only loans, reverse-amortization loans, and the like. Bad credit? 'No problem,' said the lenders. 'We'll just add some points and increase the interest rate to cover the extra risk, and make the loan.'

Because lenders were making so much money selling loans, and because there were so many lenders seeking borrowers, the business became all about origination. It became a matter of qualifying someone for a loan, any loan, by any means possible. Lenders didn't worry about what would happen when the adjustable rate reset in a couple of years, because someone else would own the loan by then. Besides, with all the refinancing, the chances that a loan made today would still exist in a few years were pretty slim. As long as rates stayed low, and housing prices increased, refinancing was inevitable. So a borrower could stay on an introductory, interest-only or reverse-amortization rate forever, lenders reasoned.

That brings us to housing prices. The increased supply of mortgage loans, and the decrease in their initial cost, caused more people to buy houses for the first time. This decade saw record home ownership rates. As demand for houses increased, prices increased. Speculators came hard and heavy, fueled by cheap credit. People flipped their houses like playing cards. This meant more mortgage origination, more refinances, and more money.

Investors liked the 'exotic' ' i.e., risky ' loans because the returns were higher. This, naturally, incentivized lenders to concentrate on those risky or subprime markets.

Oh, and let's not forget the fraud. It's only natural that the competition's making of legitimate, albeit risky, loans led originators to take shortcuts. One could write a book on the schemes invented by lenders, borrowers, and intermediaries, and still scratch only the surface.

Everything fed off everything else, leading us right to where we are today. Default rates are at historic levels. Entire neighborhoods are being threatened with foreclosures. Mortgage lenders are failing left and right.

There's no question that these two factors will play a significant role in ensuring that governments, at all levels, will be doing something about the mortgage crisis. With the media keeping the issue on the front page, it will be impossible to avoid investigation, regulation, and legislation.

How Does This Affect Me?

In several respects, the leasing industry is far different than the mortgage industry. For one thing, nothing that is leased carries the emotional weight of a home. For another, the leasing industry's primary customers are businesses, rather than consumers. But that doesn't mean the leasing industry will be immune from the effects of the subprime fiasco. The mortgage crisis will certainly have ripple effects on this industry. It also should be a cause for introspection on whether it would be beneficial to implement changes in leasing practices.

Where's the Money?

Ultimately, it's all about the money. The carnage in the CMO industry may cause capital to run from debt. Stung by the vagaries of buying pools of secured obligations, investors might be less willing to invest in lease obligations. A smaller, more-skeptical market will mean a higher cost of capital, fewer leases, and less profit.

On the other hand, capital could run from CMOs right into lease pools. When the stock market declined earlier in the decade, investors began to buy commercial real estate in a big way. Buildings began selling at multiples that were impossible to justify ' unless, of course, you were betting on someone buying you out in a couple of years. The same might happen with leases because investors have to put their cash somewhere.

Give Me My Money

The flip side of raising capital is, of course, collecting the money you are owed. It's no secret that this industry is heavily dependent on the financial situation of its customers. Those in the heavy-equipment leasing business have to anticipate the effects of a stagnating or deflating housing market. For example, Lennar Corp., a major home builder, recently withdrew its 2007 earnings goal, after its profits fell more than 73% in the three months ending February.

A bad market will mean less construction, which will mean less demand for equipment. It will likely mean increased defaults on existing leases, as companies that were too thinly capitalized find themselves unable to meet their obligations. Defaults will lead to repossessions. So leasing companies will have used equipment on their hands that they need to dispose of exactly at the time when demand for the equipment will be dropping.

Underwriting

On a longer term, I firmly believe that we are experiencing a sea change ' a tipping point, to use the popular phrase ' in the public's perception of borrowing. It used to be that pre-qualifying for a mortgage was the sine qua non of having good credit. If a bank was willing to qualify you for a loan, you knew you were in sound financial health. You could finance your house, your car, or your boat knowing that you could afford it.

That particular notion may be fading away. Lenders may no longer be seen as gatekeepers, ensuring that only the worthy are allowed through the gates to the Land of Credit. Instead, they will increasingly be viewed as enablers, pushing debt on unsuspecting or addicted marks. You can see this happening already in the credit card industry.

Credit of any kind may become a controlled substance. Certainly, there will be increased regulation of all aspects of the credit industry. Underwriting standards will be tightened. Required disclosures will increase. Government will act in various and sundry ways to put checkpoints on the path to borrowing or leasing.

Moreover, borrowers, courts, and juries may become more willing to fault predatory lenders or take notice of lender liability lurking in the depths of a defaulted loan or lease. To be sure, predatory lending and lender liability are not new. But a larger segment of the public is going to see a default as the result of a greedy or unscrupulous lender rather than a foolish borrower.

Leasing companies need to start preparing for this new reality today. Underwriting needs to be tightened. If you don't have guidelines, you need to adopt them. If you have them, you need to make sure they are followed. If you gather information about the borrower, you should incorporate it into your underwriting decision. If you rely on information, you should take reasonable steps to ensure that it is accurate. What you need to prepare for is the worst-case scenario. How will your underwriting decisions appear to the outside when a business accuses you of predatory leasing practices? Will you be able to demonstrate that you had a reasonable basis to believe that the lessee could perform its obligations, or will it appear that the lease was signed with a blind eye to a likely future default?

The goal of 21st century underwriting cannot be 'How do I protect myself against risk of default?' It will have to be 'How can I minimize and balance the risks of this transaction for all parties?' There is no question that borrowers in the mortgage industry are going to be pursuing lenders for transactions that were arguably unsound or predatory. Institutionalizing sound, justifiable underwriting practices will help guard against similar claims in the leasing industry.

Workouts

The due diligence and care required in sound underwriting does not end when the lease is made. If and when a lessee falls behind, how will you respond? Your lease will provide all manner of remedies that you can exercise, but should you jump right to the most draconian? Of course, few lessors will repossess equipment when a lessee who is honest and straightforward experiences a short-term cash-flow crunch, but you need to institutionalize a workout process. You can be damned if you do and damned if you don't. Propose a reduction in monthly payments and an extension of the lease term, and you can be criticized (and sued) for allowing the customer to dig a deeper hole than he or she already was in. Pull the plug, and you can be criticized (and sued) for killing off a business that could have recovered.

In today's climate, any aggressive action by lenders or lessors is at risk of being second-guessed. You can't eliminate this risk, but you can act
to ensure that, when the second-guessing happens, the path you
took will be seen as a reasoned and reasonable one, taken after considering most, if not all, of the potential ramifications.

One effective way of minimizing the risks of a workout is to enter into a formal standstill or 'pre-workout' agreement. In exchange for some concessions (either temporary or permanent) on your part, you may ask the lessee to agree to certain terms. These might include an express representation that you are not waiving rights by making workout proposals; the lessee's acknowledgment that your lease agreements are valid contracts and that you can exercise your rights under them; or a waiver of any claim that you are liable for any action you take in a future workout that was authorized by your lease documents.

You can also outsource the workouts. Sell the defaulted obligations to another entity that will do the heavy lifting and bear any liability for alleged overreaching. Lenders don't typically want to be in the collection business anyway. It's much more profitable to initiate the transactions than it is to collect. There is little question that the market for troubled credit will be booming in the near-term. Of course, everyone will be looking for bargains, but what else is new?

Conclusion

Though it is easy to dismiss the subprime lending crisis as a far-off storm that won't affect the equipment leasing world, it would be a mistake to do so. There are lessons to be learned from the tumult happening at that end of the credit market. As always, the people who learn the most, and the quickest, from the problems of others will outstrip their competition.

Patrick W. Begos is a partner in Begos, Horgan & Brown, with offices in Westport, CT and Bronxville, NY. The firm engages in business, financial, and insurance-related litigation, trials, and appeals in state and federal courts in New York
and Connecticut, as well as arbitrations. For more information visit http://www.begoshorgan.com/.