Here It Comes

Discussion in 'Wall St. News' started by ByLoSellHi, Jan 25, 2007.


    Tremors at the Door

    Published: January 26, 2007

    Wall Street’s big bet on risky mortgages may be souring a lot faster than had been previously thought.

    The once booming market for home loans to people with weak credit — known as subprime mortgages and made largely to minorities, the poor and first-time buyers stretching to afford a home — is coming under greater pressure. The evidence can be seen in rising default rates, increasingly strained finances at mortgage lenders and growing doubts among investors.

    Now, Wall Street firms, which had helped fuel the growth in the market by bankrolling and investing in subprime mortgage lenders, have begun to pinch off the money spigot.

    Several mortgage lenders have recently collapsed. While the failures so far are small in number, some industry officials are concerned that they could be the first in a wave. The subprime sector, which produced loans worth more than $500 billion in the first nine months of last year, could shrink significantly.

    A sharp contraction in subprime mortgages would have ripple effects, reducing consumers’ access to credit and affecting investors like foreign central banks, pensions and mutual funds that have been big buyers of mortgage-backed securities.

    The recent bankruptcy of Ownit Mortgage Solutions, a lender based in Agoura Hills, Calif., provides a cautionary tale. Even as its revenue grew by more than a third in the first nine months of 2006, to $8.3 billion, the company was losing money. It shut down after its financial backers, which included Merrill Lynch & Company and JPMorgan Chase, could not come up with a deal to save it.

    In addition to Ownit, Sebring Capital Partners, based outside Dallas, closed in December, and Mortgage Lenders Network of Middletown, Conn., has stopped making loans through brokers. It also laid off more than 800 employees and is under investigation by state regulators.

    “Pick a company — small, medium or large — they all have the same problem: capital,” said Marc A. Geredes, who runs a small mortgage company, LownHome Financial, in San Jose, Calif. “The economics of the business do not make sense right now.”

    Wall Street firms were attracted to such lenders because they helped feed a pipeline of securities backed by the mortgages, a market bigger than the one for United States Treasury bonds and notes. Merrill Lynch, for example, securitized $67.8 billion in residential mortgages in the first nine months of 2006, up 58.4 percent from the period a year earlier.

    But an increasing number of borrowers are defaulting on subprime loans earlier now than they did a year ago, often within six months of having taken the loan out, shaking Wall Street’s confidence in its subprime partners.

    In one indication that investors are losing their taste for mortgages, hedge funds that specialize in mortgage-backed securities had an outflow of $1.8 billion in 2006, down from an inflow of $1.8 billion in 2005, according to Hedge Fund Research. It was the only category of hedge funds to have a negative flow for the year.

    “We have been and continue to be cautious about the subprime market — its lending standards, decline in home price appreciation, other deteriorating credit fundamentals,” said Jim Higgins, chief executive of Sorin Capital Management.

    While Wall Street’s tolerance for mortgage risk has waned, it is still interested in mortgage originators. This week, Citigroup bought a mortgage servicing business from ABN Amro Holding for undisclosed terms, and Barclays Bank bought the Equifirst Corporation, a subprime lender, for $225 million. But something of a shakeout has begun.

    “The pendulum swung too far the other way,” said Guy D. Cecala, president of Inside Mortgage Finance, which publishes data and newsletters on the industry. “At some point, it comes back. But what it usually takes is a little blood on the road.”

    If that is indeed how the story will play out, William D. Dallas, the founder and chief executive of Ownit, would argue that his company has become an early case of road kill.

    In mid-November, JPMorgan Chase, which provided Ownit with money to make home loans, notified the company that it was in default and would lose access to a $500 million credit line by Dec. 13 because it was losing money. It had taken on too much debt and its net worth had fallen, according to bankruptcy documents and people briefed on the company’s finances.

    Mortgage lenders as small as Ownit and as big as Wells Fargo sit in the middle of housing’s food chain that starts with individual home buyers and can end with investors in exotic credit derivatives on the other side of the world. Smaller lenders like Ownit use money provided by banks like JPMorgan and Merrill Lynch to make loans that it receives from mortgage brokers, who work with the people buying homes or refinancing loans and help with the paperwork.

    Once completed, the mortgages are sold to Wall Street banks that package hundreds of loans at a time into bonds that are sold to investors and traded in financial markets.

    The bonds are sliced into different layers of risk and many investors typically accept lower returns in exchange for guarantees that they will be paid ahead of people in the lower-quality portions of the securities if borrowers default on mortgages.

    Investors also shield themselves by requiring mortgage companies like Ownit to buy back mortgages that incur “early payment defaults,” an industry term for loans that have turned bad quickly.

    In recent months, banks have sought the safety of these protective measures and grown pickier about the kinds of loans they will buy after noticing that a growing number of borrowers who took out loans in 2006 were falling behind within months. According to its bankruptcy filing, Ownit was asked to buy back $166.4 million in loans, $93 million of which was owed to Merrill Lynch.

    Merrill Lynch owned about 20 percent of Ownit and provided a credit line worth billions of dollars to the company. (Also in December, Merrill Lynch bought First Franklin Financial, a subprime lender co-founded by Mr. Dallas, for $1.3 billion from National City.)

    Ownit’s strained financial circumstances set the tone for negotiations with JPMorgan, Merrill Lynch and CIVC Partners, a Chicago-based private equity firm that owns the majority of Ownit. Mr. Dallas, who along with other executives owned about 20 percent of the company, said Merrill Lynch agreed to step in to make up Ownit’s financial shortfall and was even willing to buy the 80 percent of the company it did not already own.

    But Mr. Dallas said the deal fell apart on Dec. 7, when Merrill pulled its offer of additional funds and its representative on Ownit’s board, Michael Blum, tendered his resignation by fax.

    Mr. Blum, a managing director who heads structured finance at Merrill Lynch, declined through a spokesman to comment.

    “While it is unfortunate that Ownit closed its doors, we met every contractual obligation we had to them,” William Halldin, the spokesman for Merrill Lynch, said. “Like its majority owner, we did not think it was in the best interests of our shareholders to make a further investment.”

    The representative of CIVC Partners on the board of Ownit, Daniel Helle, did not return calls for comment. Officials at JPMorgan declined to discuss the negotiations.

    Mr. Dallas acknowledged that Ownit, like other subprime lenders, saw a sharp increase in defaults from new borrowers in 2006, compared with 2005 and 2004 — years when few loans showed early losses. But he said the defaults were still low at 2 percent and insisted that most of those borrowers had simply missed one or two payments because they were confused about where to mail payments, because many of them had two mortgages on their homes.

    Across the industry, 2.6 percent of the subprime loans securitized in the second quarter of 2006 had been foreclosed on or repossessed within six months. That is up from 1 percent for loans securitized in the second quarter of 2005, according to Moody’s Investors Service, the ratings agency.

    Joseph Rocco, an analyst with Moody’s, noted that foreclosure rates typically rise as loans get older.

    The grim statistics reflect the sharp slowdown in housing. Home prices, for instance, in many previously hot markets on the coasts and in the Southwest, are falling as sales have slackened, making it harder for homeowners to sell their properties.

    They also indicate that mortgage lenders became more generous last year, giving 100 percent financing and allowing borrowers to state their incomes with little or no documentation in an effort to bolster volume, according to industry experts.

    Banking regulators have increasingly voiced concerns about the loosening of lending practices by subprime lenders. Late last year some demanded that applicants be more closely vetted before being qualified for adjustable-rate and other risky loans.

    Yet, housing advocates and industry experts say policy makers are also worried that too sharp a pullback in lending by Wall Street and commercial banks could cut off consumer access to credit.

    For his part, Mr. Dallas acknowledges that standards were lowered, but he placed the blame at the feet of investors and Wall Street, saying they encouraged Ownit and other subprime lenders to make riskier loans to keep the pipeline of mortgage securities well supplied.

    “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans,” he said. “What would you do?”