The effect of the subprime squeeze on prime lending

Over at Calculated Risk, Tanta makes a very good point about the dramatic decrease of subprime capacity:

The main impact of subprime lending on the overall mortgage business was the take-out function. As subprime lending grew, you saw better “performance” of prime or near-prime mortgage portfolios. This was not because subprime lending did away with the traditional default drivers of job loss, illness, divorce, or disorderly conduct; it was because loans in that kind of trouble had a place to go besides foreclosure. Prime lenders could and did congratulate themselves on their low foreclosure rates as if it were a matter of their superior underwriting skills, but that involves a high degree of naiveté. It’s really important to understand this issue, because it gets to the heart of the “contagion” thing. It is not that subprime delinquencies are “spreading” to prime loans as if some infectious agent were in play. It’s that the drain got backed up: when subprime lenders go out of business, or investors won’t buy subprime loans, there is no place for the inevitable prime delinquencies to go except foreclosure. Prime delinquencies become “visible” because they don’t move out of the prime portfolio via refinance into the subprime portfolio, where we “expect” to see them.

In other words, because there is less subprime capacity to take out troubled loans that were made as prime, some of these loans will now default because they have nowhere to go. Subprime provided a valuable rescue function to the prime market, and now it is mostly gone, the consequences for both lenders and borrowers of a loan falling out of the prime performing bucket are much more severe.

This implies of course that there is a lot of money to be made by stepping up to the subprime plate now, with rigourous underwriting criteria, very prudent liquidity risk management and a whole shedload of capital. Just as we saw a lot of fresh capacity in non-life insurance after Katrina, so it would make sense for new players (those private equity players with a lot of money and nothing to spend it on, for instance) to come to support the mortgage market while the established players are licking their wounds and sulking in their dens.