It was about a decade ago that Dan Perl chucked it all in to go surfing in Mexico. As a veteran underwriter of subprime mortgages, he'd seen enough by April 2007 to know that there was serious trouble ahead. So he pulled down the shutters, took an extended break in Baja, California, and then lay low for a few years, trading loans for a New York firm, Carl Marks & Co.
But now he is back in the game, leading a small band of lenders making subprime loans once more. Or "nonprime", as they prefer to call it these days. The sector is on course to produce about $10bn this year — a tiny slice of America's $1.6tn overall home-loan market but one that's growing rapidly.
Plenty of people told Perl, 68, that he couldn't bring this stuff back so soon after the global financial crisis, and after regulators all over the US radically tightened rules on mortgages. People said he was risking his net worth, that he'd "be sued into oblivion".
"How many times we hear that, Kyle?" he asks, turning to his protégé, 39-year-old Kyle Gunderlock, who was a VP of sales at Perl's old firm and is now president of the new one, known as Citadel Servicing Corp, based in Irvine, California.
"'You guys are going to get f***ing arrested,' is the one I always remember," says Gunderlock.
The way Perl and his peers see it, there's nothing shady or menacing about the business of subprime. On the contrary, they say, specialist lenders in this area are performing a vital service for the world's largest economy. For every comfortably off professional who could walk into a branch of Chase or Wells Fargo and get a home loan without any fuss, they argue, there are many more who would struggle. People who are self-employed or on variable incomes, for example, may not check all the boxes a big bank needs. Ditto new immigrants with thin credit histories, or people with a few scratches and dents in their files.
"Making credit available to borrowers who are subprime is national policy and it is an important part of economic growth," says Julian Hebron, head of sales at RPM Mortgage in Alamo, California. "It's untrue to call it a scourge."
But what's worrying some economists is a feeling that we're on a slippery slope; that the same forces which fed the crisis last time round — rampant demand for yield among investors, skewed incentives on Wall Street and a government determined to relax regulatory restraints — could feed another.
Under President Donald Trump, for example, agencies are under orders to review just about every financial rule that emerged under Barack Obama. In June, the Treasury department put out a report saying that tight underwriting standards were partly to blame for "anaemic" growth in housing, which accounts for almost one-fifth of GDP.
The market for securitising subprime loans is picking up, too, spreading the risk of default in much the same way as before. Fitch, the credit rating agency, expects $3bn of issuance of nonprime mortgage-backed securities (MBS) this year, up from about $1bn over the previous 18 months. (Back in January, it was predicting $2bn for the year.)
Meanwhile, some old characters are re-emerging, including a few who gained a certain notoriety a decade ago. Kyle Walker, the former head of Fremont, a big mortgage firm that was rapped by federal regulators for "unsafe" practices in March 2007, is back running a nonprime shop called HomeXpress in Newport Beach, California. Dan Sparks, a former Goldman Sachs trader mentioned more than 500 times in a Senate report on the mortgage meltdown, is now buying low-grade loans from a hedge fund up in Stamford, Connecticut. (Walker did not respond to requests for comment and Sparks declined to comment.)
All of this is happening without a proper reckoning from the last time around, says Richard Bowen, a former chief underwriter at Citigroup, which ranked as America's top subprime lender in 2007. Bowen says he tried to raise the alarm internally about rampant fraud in mortgage applications, before being stripped of underwriting responsibilities. He left the group in 2008. He draws a contrast with the savings and loan crisis in the US in the 1980s, after which about 800 senior bankers went to jail. The running total from the crisis that began in 2007? Zero. Even though it was "many, many, many" times worse, says Bowen, "no one has been held accountable. And I can assure you it's not because of a lack of evidence."
On the morning I meet Perl, on a blazingly hot day in June, he'd been up the hills behind his house in San Juan Capistrano with his white Labrador Ella. Now he's showered and holding court in his office, dressed in jeans, loafers and a checked shirt.
He was born in Brooklyn to a conservative Jewish family but grew up in Sherman Oaks, a relatively spacious suburb of Los Angeles, and Santa Monica. After a degree from UCLA and an English teaching job at Santa Monica High, he formed a loan brokerage in the mid-1970s with his college pal Bill Ashmore, who now runs Impac, another mortgage firm based a few miles up the San Diego Freeway from Citadel.
After the crash of 1987, Perl-Ashmore parted ways; Perl into subprime (or "Bs and Cs", as lower-grade loans were called then) and Ashmore into "Alt-A", slightly classier yet not quite prime. In the 1990s Perl's business grew strongly, partly on the back of a loan he invented called the NINA — aimed at customers with "no income, no assets". He was known as the Big Kahuna.
But by 2005, says Perl, it was clear that things were slipping out of control. His outfit, then known as First Street, was a top 20 underwriter nationwide, in a sector which produced about $1tn of subprime mortgages — about one-third of the total US mortgage market — that year. Also clustered in Orange County were some of the best-known subprime shops in the country, such as New Century, Ameriquest and Fremont.
But margins were shrinking and loans were being written that should never have been written. At one point New Century had a 2 per cent error rate, meaning that one in every 50 of its borrowers never made a single payment. The company's collapse in early April 2007, owing $8.4bn to banks including Morgan Stanley, Barclays and UBS, was one of the defining moments of the crisis.
Mike Fierman, managing partner and co-CEO of Angel Oak of Atlanta, Georgia, was also in the thick of it back then, running a firm called SouthStar Funding. He says he had no choice: if he wanted to compete, he had to drop standards. Like Perl, he bailed in April 2007, after Goldman and Lehman Brothers said they'd had their fill of subprime. But until that point they and other investment banks had hoovered up everything he'd offered them. They'd then wrap it up into MBS, on which credit rating agencies — competing between themselves to win the most business — would typically slap an attractive rating.
"Everyone was complicit," says Fierman. "You felt trapped; investors were demanding more loans than could be produced in a responsible way. The only way to produce that kind of volume was to be irresponsible."
Brokers were going after "gardeners and serving maids and house cleaners and gas-station attendants and strippers on poles," says Perl. "That's not lending. That ain't the way you do it."
He got out about 18 months before the collapse of Lehman brought the world economy to the brink of ruin. "Honest to God, Ben, do you ever just get a bad vibe?" he asks me. "Do you ever walk down a dark hall and say, 'This is not a place I should be?'"
This time it's different, say the lenders. Thanks to the Dodd-Frank Act of 2010, the nonprime loans being written now bear little relation to the sludge that stunk up the system a decade ago.
Perl and Gunderlock say they spent weeks going through the 800 pages of Dodd-Frank that was relevant to mortgages, as they looked to crank up the machine again. There were all kinds of proscriptions on funding and closing and servicing a loan, says Perl, but in the end it came down to this: "People have to be relatively reasonable about how they treat borrowers. You can't lie, you can't cheat, you can't steal."
Gone, as a result, are some dubious features that caused trouble last time round, such as zero deposits or low teaser rates that adjusted sharply higher in two or three years. Gone, too, are the negative amortisation loans that allowed borrowers to pay less than the interest due, so that the loan balance actually grew.
There's no more "stated income" either: whatever the borrower declares, the lender has to check by looking at pay stubs and tax returns, rather than assuming it's the truth.
Granted, standards in nonprime are generally looser than those that apply to mortgages eligible to be bought by government agencies such as Fannie Mae. Such loans are known as "qualified mortgages", or QM, and they account for the vast majority of America's home-loan market.
But today every mortgage has to conform to an overarching standard known as ATR, or "ability to repay". Unless a lender can be convinced in eight separate ways that the borrower has the means to pay the thing back, it can be sued down the track if the loan goes bad.
The new regulatory framework is "actually pretty rational", says Matt Nichols, founder and CEO of Deephaven Mortgage, who set up the Charlotte, North Carolina-based firm in 2013 after more than a decade running Goldman's residential mortgage business. So far he's bought about $1bn of nonprime loans from a network of 100 or so brokers, and has resold about half of that into the MBS market.
In a $250m MBS deal in June, more than 40 per cent of borrowers who got mortgages bought by Deephaven had had a prior "credit event" such as a bankruptcy, foreclosure or short sale, according to Kroll, a credit rating agency. The deal was roughly six times oversubscribed, nonetheless.
"Ability to repay, as a rule, is common sense," says Nichols. "You've got to rely on something other than their word for it, right?"
Perl and others note that investors in these new classes of nonprime MBS have extra degrees of comfort. Under Dodd-Frank reforms that took effect in 2015, sponsors of a deal need to retain an interest of at least 5 per cent of the aggregate credit risk of the assets they're turning into securities. It's known as "skin in the game": if originators are on the hook for losses, the theory goes, they'll take a lot more care over what they're producing.
Before the crisis, there was no minimum ownership, resulting in mortgage firms simply flipping all kinds of dross at Goldman or Merrill or Bear Stearns. "This is not an originate-to-sell model; it's an originate-to-own model," says Fierman of Angel Oak. His firm, which buys nonprime loans from other brokers as well as originating its own, has been the most active of MBS issuers, completing four deals since 2015 worth a total of $630m. He says that Angel Oak has gone well beyond the basic 5 per cent threshold, owning as much as 10 per cent of its MBS deals at various points. "Trust has to be built with investors," he says. "They're watching us closely."
Some of the big names on Wall Street have already tiptoed back in. Pimco, the world's biggest bond house, has 25 per cent of the equity in Perl's Citadel, according to a person familiar with the ownership structure. Blackstone, the private equity giant, has a cluster of nonprime investments, including a stake in Bayview Asset Management, a firm which buys mortgages from Coral Gables, in Florida.
Will the big US banks get back into subprime? Inevitably, says Guy Cecala, CEO and publisher of Inside Mortgage Finance, the industry bible. He notes that overall mortgage originations in the US have slipped about one-fifth this year, mostly because a rise in interest rates has caused refinancing business to drop.
"At the end of the day, every lender out there, unless they want to see their business decline, has to look at alternative products," he says.
In the meantime, other banks are taking supporting roles. Credit Suisse and Nomura, for example, are supplying lines of credit to originators and underwriting securitisations of subprime mortgages. Fitch, DBRS and Kroll, the credit rating agencies, have given their stamps of approval to a succession of securitisation deals.
Even Standard & Poor's, which paid $1.4bn in 2015 to the US Department of Justice to resolve a probe into ratings inflation, is back on the scene, rating five deals this year. (Moody's, which settled with the government in January this year, has yet to re-appear.)
Some investors, for their part, are reluctant to dive in. Tracy Chen, a fund manager at Brandywine Global in Philadelphia, says she's tempted, but wants the MBS market to increase to about $20bn in total before she would feel comfortable trading in and out of positions. "The market is still not very transparent, and there's not much trading volume. I need to wait for it to scale up before I enter." The caution is understandable: she was at UBS in the run-up to the crisis, when the Swiss bank took tens of billions of dollars of losses on its subprime portfolio.
But even the more cautious investors may change their minds, in time. As long as interest rates stay near historic lows, "anyone will scramble for what yield they can find", says Bowen, the ex-Citigroup whistleblower, who now lectures on ethics.
He cites the sale of junk bonds in August by Tesla, the trendy carmaker that is still consuming much more cash than it is earning. The $1.8bn deal, which lacks restrictions to stop Tesla issuing more debt whenever it wants to, is "insane", he says.
For now, loan books are in good shape. At Impac, just a handful of non-QM loans written over the past three years are more than 60 days delinquent, says Ashmore, the CEO. Only one loan is in foreclosure, among about 2,200 in total.
He expects the total nonprime market to increase to $100bn before long. "I believe if I can deliver superior risk-adjusted returns, there'll be more than enough capital."
At Citadel, which normally aims a notch or two below the typical Impac customer, in terms of credit score and debt-to-income ratios, there are seven foreclosures among 3,500 or so loans. That has prompted Perl to push out the boat a bit. In August he launched a new loan called "The One", allowing a self-employed borrower to qualify based on one month's bank statement rather than the usual 12.
The move has "got everyone a little nervous", he admits, despite a long list of safety features. But he reckons he has another four to five years of "clear sailing" before the market starts to turn once more.
One regret? Not trademarking "nonprime", which he thinks he coined five years ago.
As for "subprime", he never liked it.
"It sounds kind of Neanderthal, doesn't it? It sounds almost like you're a monkey and humans are better. But nonprime has a nice ring to it."