Watch Those Servicing Assets.(home equity loans)

Lenders are reacting to a changing marketplace. Experienced players see a familiar shifting cycle, increasing home-equity or subprime lending to compensate for flagging refinance business. As this trend continues, it poses new risks for servicers. Refi volume fell from $319 billion in the first quarter of 2004 to $262 billion by the fourth quarter, according to the Mortgage Bankers Association. This business, which accounted for over 50% of the overall lending volume in 2003, will account for less than 23% in 2006. Purchase business alone cannot make up this gap.

As the industry turns to home-equity product, data indicate that all A-paper home-equity lenders are competing for the same borrowers. Conventional paper in this sector is originated almost exclusively for borrowers with FICO scores within about 25 points of each other. As this market becomes saturated, lenders will be forced to target borrowers outside this credit range, leading to riskier deals.

Subprime lending has become increasingly popular since the 1990s, but over the past year or so has grown dramatically. There are a number of reasons for this. Technology has made it easier for competitors to get into this business. Subprime automated underwriting tools, virtually unknown in the 90s, are common now. In addition, improved risk mitigation tools have brought more investors to the table.

These loans carry higher risks because of the nature of the borrowers that are attracted to these products. According to the Federal Reserve Board, serious delinquencies in subprime are more than seven times as high as delinquencies in a conventional loan pool. However, as lenders struggle to maintain their previous origination levels, it is clear that more borrowers from these lower credit grades will be securing mortgage loans.

It doesn't take a crystal ball to see that delinquencies and foreclosures are going to rise in the months ahead. Servicers are already gearing up to deal with more REO. But there are other steps they can take now to mitigate these risks.

The first step in mitigating delinquency and foreclosure risk in these portfolios is to keep better tabs on these borrowers. The most successful subprime servicers are prepared to take action the minute a loan payment becomes delinquent. But timely principal and interest payments are not the only liabilities that must be monitored. Property taxes and insurance must also be paid on time.

Because interest rates and closing costs are higher on subprime loans, originators may forgo setting up ...