Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
trends, conditions, and other relevant factors, including
business volume, underwriting, risk selection, account
management practices, and current economic or business
conditions that may alter such experience.
Subprime Auto Lending
Underwriting. Subprime auto lenders use risk-based
pricing of loans in addition to more stringent advance rates,
discounting, and dealer reserves than those typically used
for prime auto loans to mitigate the increased credit risk.
As credit risk increases, advance rates on collateral
decrease while interest rates, dealer paper discounts, and
dealer reserves increase. In addition to lower advance
rates, collateral values are typically based on the wholesale
value of the car. Lenders will typically treat a new dealer
with greater caution, using higher discounts and/or
purchasing the dealer’s higher quality paper until a
database and working relationship is developed.
Servicing and Collections. Repossession is quick,
generally ranging between 30 to 60 days past due and
sometimes earlier. The capacity of a repossession and
resale operation operated by a prime lender could easily be
overwhelmed if the lender begins targeting subprime
borrowers, leaving the lender unable to dispose of cars
quickly. Resale methods include wholesale auction, retail
lot sale, and/or maintaining a database of retail contacts.
While retail sale will command a greater price, subprime
lenders should consider limiting the time allocated to retail
sales before sending cars to auction in order to ensure
adequate cash flow and avoid excessive inventory build-up.
Refinancing resales should be limited and tightly
controlled, as this practice can mask losses. Lenders
typically implement a system for tracking the location of
the collateral.
Subprime Residential Real Estate Lending
Underwriting. To mitigate the increased risk, subprime
residential real estate lenders use risk-based pricing in
addition to more conservative LTV ratio requirements and
cash-out restrictions than those typically used for prime
mortgage loans. As the credit risk of the borrower
increases, the interest rate increases and the loan-to-value
ratio and cash-out limit decreases. Prudent loan-to-value
ratios are an essential risk mitigant in subprime real estate
lending and generally range anywhere from 85 percent to
90 percent for A- loans, to 65 percent for lower grades.
High loan-to-value (HLTV) loans are generally not
considered prudent in subprime lending. HLTV loans
should be targeted at individuals who warrant large
unsecured debt, and then only in accordance with
outstanding regulatory guidance. The appraisal process
takes on increased importance given the greater emphasis
on collateral. Prepayment penalties are sometimes used on
subprime real estate loans, where allowed by law, given
that prepayment rates are generally higher and more
volatile for subprime real estate loans. Government
Sponsored Agencies, Fannie Mae and Freddie Mac,
participate in the subprime mortgage market to a limited
degree through purchases of subprime loans and guarantees
of subprime securitizations.
Servicing and Collections. Collection calls begin early,
generally within the first 10 days of delinquency, within the
framework of existing laws. Lenders generally send
written correspondence of intent to foreclosure or initiate
other legal action early, often as early as 31 days
delinquent. The foreclosure process is generally initiated
as soon as allowed by law. Updated collateral valuations
are typically obtained early in the collections process to
assist in determining appropriate collection efforts.
Frequent collateral inspections are often used by lenders to
monitor the condition of the collateral.
Subprime Credit Card Lending
Underwriting. Subprime credit card lenders use riskbased
pricing as well as tightly controlled credit limits to
mitigate the increased credit risk. In addition, lenders may
require full or partial collateral coverage, typically in the
form of a deposit account at the institution, for the higherrisk
segments of the subprime market. Initial credit lines
are set at low levels, such as $300 to $1,000, and
subsequent line increases are typically smaller than for
prime credit card accounts. Increases in credit lines should
be subject to stringent underwriting criteria similar to that
required at origination.
Underwriting for subprime credit cards is typically based
upon credit scores generated by sophisticated scoring
models. These scoring models use a substantial number of
attributes, including the frequency, severity, and recency of
previous delinquencies and major derogatory items, to
determine the probability of loss for a potential borrower.
Subprime lenders typically target particular subprime
populations through prescreening models, such as
individuals who have recently emerged from bankruptcy.
Review of the attributes in these models often reveals the
nature of the institution’s target population.
Servicing and Collections. Lenders continually monitor
customer behavior and credit quality and take proactive
measures to avert potential problems, such as decreasing or
freezing credit lines or providing consumer counseling,
before the problems become severe or in some instances
before the loans become delinquent. Lenders often use
DSC Risk Management Manual of Examination Policies 3.2-71 Loans (12-04)
Federal Deposit Insurance Corporation