Garnet Capital Advisors Blog

August 17, 2016

It's NOT Subprime: It's NEAR Prime

"Subprime" is a word inextricably linked, in the minds of the public, with the Great Recession and the financial crisis. Because of the association between the two, banks avoid using the word "subprime;" it's become impolite to utter aloud.

But another word is popping up as banks discuss their quarterly earnings. It's "near prime," used by banks like J.P. Morgan Chase, Wells Fargo, US Bancorp, and T.D. Bank.

Near prime is the next tier after prime.

"Near prime" is the new subprime. Essentially, it's the next tier after prime. Borrowers whose FICO credit scores are a minimum of 720 out of the FICO range of 300 to 850 are prime. While there is no officially established range for near prime, the Wall Street Journal indicated it usually ranged from the mid-600s to the low 700s. The near prime category indicates that the borrowers may have skipped debt payments in their history or may have large credit card debt outstanding.

Near Prime as a Growth Strategy
Banks are using near prime loans to increase their loan volumes. A long period of low interest rates has eroded profit margins. In addition, some believe that expansion driven through prime borrowers is already largely in the market, and to drive volume further, a drop down the FICO ladder is necessary. Near prime borrowers are the next potential market to expand loan volumes.

Lending to near prime borrowers has expanded most dramatically in auto loans. Consumer demand for auto loans is high due to the strengthening economy and low gas prices.

Auto loans to near prime borrowers have risen.

What Does the Future Hold?
Given that subprime lending was one of the catalysts of the financial crisis, one question arises: will there be a lending crisis on the rise in auto loans to near prime borrowers, analogous to the subprime lending on mortgages that helped trigger the financial crisis?

Most observers say no, for several reasons. First, the market is much smaller. Auto loans to all borrowers are roughly a $1 trillion market, versus a market of $8.4 trillion for mortgages.

Second, subprime borrowers are a small percentage of the auto loan market. They represent 22% of auto loan borrowers versus 25%-30% pre-financial crisis. Delinquencies do not constitute a high percentage; only 10% of subprime borrowers are projected to default on their auto loans this year, less than the 13% reported in 2009.

Third, near prime lending is part of a balancing act by which banks continually assess the credit-worthiness of their lenders. By sticking to near prime, banks hope that rising loan volumes will counterbalance any defaults.

Finally, collection is easier. It is easier to repossess a car than to sell a foreclosed home.

Implications for Banks
Nonetheless, there are implications for banks, of course. Several banks including J.P. Morgan Chase, Wells Fargo, Capital One Financial Corp., and Discover Financial Services, recently reported that they were increasing their reserves on expectations of an increase in loan losses.

One strategy for banks dealing with the current loan environment is to manage their loan portfolios wisely. A seasoned loan sale advisor can help banks with prudent loan portfolio management by adding or selling loan pools.

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