Eighth Edition - Covering 2006 Through 2008
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Eighth Edition - Covering 2006 Through 2008 |
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The subprime industry that mortgage professionals knew from 2000 to 2007 has been wiped off the face of the map. That's a blunt statement, I know. But there's no better way to say it. It's best to get the issue at hand out in the open. In 2005, a record year for subprime lenders, loan production in the "non-prime" space totaled $795 billion, or 24% of all loans being funded that year. In 2008 subprime production will total just $30 billion or 1.8% of all loans funded. That's not a type-o. It's reality. These are unprecedented times in the housing and mortgage finance industries. More than 150,000 mortgage jobs alone (out of a peak of 500,000) have been lost over the past 18 months. Several thousand more likely will go down the road before the industry stabilizes.
And just when will the subprime sector come back? And will it ever come back, and if so, to what degree? These are some of the questions we will attempt to answer in this chapter of The Mortgage Industry Directory. But before we even get to the "recovery" issue, it's important to look back at what happened in the credit and mortgage markets over the past two years to see why the business imploded. As this book went to press, banks, thrifts and investment banking firms had taken $300 billion worth of writedowns on their mortgage holdings, including MBS, ABS, collateralized debt obligations (CDOs), whole loans, servicing rights and the like. In the years ahead some of these huge writedowns might be recaptured but chances are the "write-ups" will be miniscule. (Note: writedowns feed into quarterly losses and are set-asides that can be recaptured when delinquencies are cured.)
In every financial crisis there are victors - firms that have the moxy to step in amongst the rubble, bottom-fishing for assets (in this case delinquent and under-performing loans) that depositories and investment banking firms desperately want to get rid of. There will be victors in this crisis too. We'll get to that later on in the chapter. First let's ask the basic question: how did the subprime crisis - one that has infected the entire U.S. economy and other nations too - happen? Who screwed up?
If you are somewhat new to the mortgage industry (less than 10 years of service) you likely have no idea that subprime lending was once called by other names: hard money, home equity, and B&C to name the most common. And it's safe to say the subprime business of yesteryear had little in common with the industry of 2000 to 2007. The only thing they had in common was the fact that they lent money to consumers with not-so-great credit.
The business of making home mortgages to consumers with blemished credit started in the mid 1960s when Beneficial Finance and other "consumer finance" companies (that were looking to expand their product offerings, and thus profits) began to branch out by offering second liens (second deeds of trust) to home owners who needed money. These borrowers tended to be both blue collar factory workers and gray collar employees of limited means. The reason they turned to consumer finance lenders: they were ignored by their neighborhood banks and thrifts, most of which only wanted to deal with 'A' paper borrowers. (This was also an era before the Community Reinvestment Act laws had been passed which mandated federally insured depositories to make a certain dollar volume of loans in neighborhoods where they had branches.)
Prior to this time, Beneficial, Household Finance, and Associates First Capital Corp. - the 'granddaddies' of the consumer finance business - specialized in making personal loans to working Americans. Sometimes these loans were collateralized by hard goods such as automobiles and furniture. The chief reason Beneficial made personal loans was that they could charge higher than prevailing interest rates. If a 30-year fixed rate mortgage was 8%, for instance, Beneficial might charge 5 full points more, or 13%.
For decades, consumer finance was a profitable business to be in - as long as Beneficial's loan officers properly underwrote the loans, which they did. Back then LOs ordered up credit reports, carefully analyzed the borrower's ability to repay and even collected on the loan each month. (In the 1960s many consumer finance borrowers paid in cash.) Can you imagine a modern day subprime mortgage LO doing all that grunt work? No. In the modern era (before the business cracked up) subprime LOs and account executives took an application, fed the information through a computer where a software program scored it and then it was all systems go - as long as the appraisal on the house checked out. At least, that's how many wholesale subprime funders (many of them non-depositories) conducted business over the past five years. In some cases appraisals weren't even done. Instead the wholesaler, anxious to fund the loan, went out and bought an automated valuation model (AVM) over the Internet. The thinking was this: why waste time and money by doing a physical appraisal when you can buy a cheaper "canned" appraisal over the web.
In the 1960s and 1970s when consumer finance firms branched out into making second deeds of trust, they looked to the collateral, in this case the house, for repayment. Second mortgages were not extended unless the loan officer (acting as an agent of the company) thought he/she could get all the company's money back in the event of default. "Getting all the money back" meant foreclosure and that, in turn, meant the house had enough equity in it that asset recovery would not be an issue. Year after year consumer finance companies turned respectable profits on their home equity lending operations because they did not take huge risks. It was risky (of course) lending money to consumers with less-than-perfect credit, but the Beneficial's and Households of the world only made second deeds of trust if the combined loan-to-value ratio (along with the first lien) was in the range of 60% to 70%. Their delinquencies were relatively low - less than 5%. In July 2008 Countrywide/Bank of America, the nation's largest subprime servicer with receivables of $106 billion had a delinquency rate of 33%. Ouch.
It wasn't until the late 1980s and early 1990s when hard money lending began to morph into something else entirely. Beneficial, Household, and Associates were still humming along, funding second deeds of trust, but savings and loans in Southern California - in particular Long Beach Savings and Guardian Savings - began to stick their toes into subprime. The business still entailed funding mostly second deeds of trust, but some thrifts began making first liens by refinancing the existing mortgage, allowing the consumer to take cash out of his/her house. Guardian eventually failed - because it also had funded large commercial loans that went south - but its subprime business was deemed a model operation and a decent success.
Long Beach Savings, which was owned by California businessmen Roland Arnall, eventually turned in its thrift charter to the government and became a non-depository mortgage banking firm that specialized in subprime. Both Long Beach Mortgage (LBM) and Guardian began using loan brokers that sourced loans for them. It's important to remember that up until the early 1990s most consumer finance companies relied exclusively on their retail store front branches. Table funding through loan brokers was not something Beneficial and Household did during their early years as subprime pioneers. Not until the end of the 1990s did these two companies engage in third-party lending through brokers and correspondents.
In 1995 mortgage lenders (most of which were non-depositories) funded $35 billion in loans to subprime borrowers. In that year subprime production accounted for about 5.5% of every loan written in the U.S., on par with the government-insured market of FHA and VA-insured loans. (Don't forget: ten years later, in 2005, subprime would account for 24% of every mortgage funded, or $795 billion.) But how, exactly did subprime lending grow so rapidly over that 10-year period? What was the impetus? It can be argued that Wall Street firms provided an overabundance of liquidity to the market. Why, you may ask? Answer: because Street firms like Bear Stearns, Lehman Brothers, Credit Suisse and others, knew they could package non-prime loans into high yielding bonds that could be sold to institutional investors in both the U.S. and overseas. Wall Street, as always, was profit-driven.
Investors, presumably, would snatch up these subprime-backed bonds because the yields on them were a couple of points higher than on Fannie Mae/Freddie Mac bonds. Why would an investor take a risk on mortgage "junk" bonds (subprime MBS)? Answer: a point or two extra yield on a multi-million bond can yield millions of dollars in additional income.
According to figures compiled by Thomson Financial (which used to own National Mortgage News, the publisher of this book), just $20 billion worth of subprime bonds were issued in 1995. By 1998 that number had quadrupled to $100 billion. Wall Street saw gold in them thar subprime hills. Around this time a whole new breed of subprime lender had emerged in the market place: non-depositories, some of which were publicly traded, using warehouse lines of credit provided to them by Wall Street and big money center banks like First Union. By 2005 subprime securitizations exploded to $510 billion a year. Almost every Street firm wanted in on the game or already was in it: Bear, Citigroup Securities, Credit Suisse, Deutsche Bank, Goldman Sachs, Greenwich Capital, and Merrill Lynch.
In the mid to late 1990s Wall Street was not only buying and securitizing subprime loans but they were racking up investment banking fees by taking non-depository lenders public. They were also providing warehouse lines of credit to companies like Cityscape Financial, First Alliance, Southern Pacific Funding, and United Companies. By offering one-stop shopping to these lenders, Wall Street (Bear Stearns, Lehman, Greenwich Capital, and other firms) had a lock on their business. Keep in mind one important thing about the investment banking industry of this era: Glass-Steagall, a law that separated traditional banking from traditional investment banking (bond underwriting, in particular) activities was still in place. Glass-Steagall was finally repealed at the tail end of the Clinton Administration after years in which the banking industry had reportedly spent $300 million in lobbying costs. Banks could now underwrite bonds of all sorts - including mortgage-backed bonds, especially on non-prime loans. If Glass-Steagall had never been repealed commercial banks would not have suffered the huge writedowns they began taking in 2007 and all through 2008.
In 1995 subprime lending began to accelerate but not dramatically, at least not yet. That year, the largest subprime servicer in the land was Ford Consumer Finance of Irving, Texas, which had a $14.3 billion portfolio. Its next closest competitor was The Money Store, Union, N.J. with $5.8 billion. New entrants began paying careful attention to the business because they realized they could make what appeared to be a phenomenal amount of money on a very small volume of originations. (See table below.)
Just how good were profit margins in subprime during this time? National Mortgage News, the publisher of this book, analyzed half-year profits posted in 1997. The newspaper found that First Plus Financial of Texas earned a net profit of $68 million on originations of just under $2 billion. By comparison Norwest Mortgage (a subsidiary of Norwest Bancorp) earned $69 million on originations of $22 billion. Stated differently, when it came to 'A' paper lending it took 11-times the volume to earn the same money as a subprime funder. Subprime looked like a gold mine. By the end of 1997 there were more than 100 lenders actively originating A- to D loans and at least 50 different wholesalers gathering product through loan brokers.
One of the chief reasons profits looked so good had to do with the securitization of mortgages using 'gain-on-sale' accounting. With gain-on-sale (GOS) lenders could book all profits on their loan sales (into securities) even if they held onto the risky 'B' piece securities. In other words, as long as ContiMortgage, First Plus, The Money Store and the others conservatively valued the 'B' pieces they kept, everything would be fine. (The 'B pieces' were the riskiest parts of the bonds, the ones where the first losses occurred.) But that's not what happened. The assumptions they made in regard to how long the loans would stick around on their books turned out to be overly optimistic. The biggest mistake many of these firms made was that the subprime mortgages they had securitized would stick around for years longer than they had forecast. As Mike McMahon, a stock analyst for Sandler O'Neill noted, "They were way too optimistic on the life of the loans," he said. "Everyone was guessing with limited historical data." Historical data? As far as securitization went, subprime mortgages originated using loan brokers had no history. Everyone was guessing.
Then the Russian Debt Crisis struck in the summer of 1998. Many hedge funds, which had been buying the risky 'B' pieces, pulled out of the subprime market entirely. That was one problem. Complicating matters was the collapse of Long Term Capital Management (LTCM), a huge private hedge fund operated by John Meriwether, a former star bond trader at Salomon Brothers. Under Meriwether, LTCM was speculating in international bond markets and had bet the wrong way on Russian debt - just as that nation was devaluing the ruble. LTCM's biggest problem: it had borrowed $125 billion from commercial banks and investment banking firms. It had lost so much money that the Federal Reserve stepped in and orchestrated a rescue plan for LTCM.
The phrase "risk aversion" crept into the investment banking lexicon. Wall Street firms that had been extending warehouse lines of credit to non-bank subprime lenders began margin calling them. After awhile, financing dried up. Combined with the over-optimistic GOS assumptions, dozens of subprime firms began to collapse. A few - like The Money Store - found new owners and survived awhile longer before eventually failing as well. (The Money Store was bought by First Union Bancorp for $2.1 billion. Eventually the bank closed the lender, writing down its value to zero.) The nation's "first" subprime debacle had come and gone.
There are a few important distinctions between the first subprime crisis and the second one. The A- to D loans originated during the last half of the 1990s were not riddled with underwriting problems. As many subprime and prime executives alike have pointed out, it was not a credit quality problem that tanked the industry in 1998 and 1999. GOS abuses and faster-than-expected loan prepayments did most of the damage. (Loan brokers were accused of refinancing their own subprime customers, churning loans and raking in huge fees and points. This supposedly made prepayment assumptions worthless.) And it didn't help that Wall Street warehouse lenders were less than understanding when it came to helping their customers who were in distress.
Still, quite a few lenders survived the '98/'99 debacle only to emerge stronger and more dominant than ever. Associates First Capital Corp., and Household Finance were at the top of the heap. Both survived because they were portfolio lenders that eschewed securitizing their subprime production and getting hooked on 'gain-on-sale' accounting which let them sell loans into securities and book all of tomorrow's profits today. On the surface booking "tomorrow's profits" today might be all well and good as long as you made conservative assumptions about how long the bonds you issued from those mortgages would stick around (the life of the loans). But the assumptions many subprime securitizers made - companies like Cityscape, The Money Store, and United Companies - were wildly flawed. The underlying loans prepaid much faster than anticipated.
When the smoke cleared from the 'first' subprime crisis, Associates Household, and Roland Arnall's Ameriquest were poised to control the subprime market. Mr. Arnall had spun-off his subprime wholesale firm, Long Beach Mortgage via an IPO. Eventually LBM was sold to Washington Mutual. Mr. Arnall re-entered the space with a retail subprime lender, Ameriquest, and a wholesale division, Argent Mortgage. Both these companies ramped up production, advertised and marketed heavily. In 2005 Ameriquest/Argent reportedly earned $1 billion (pre-tax.) The future looked bright for subprime.
By early 2006 the subprime business looked like a sure bet to Wall Street but one thing had changed when it came to the basic economics of the business: the Federal Reserve had hiked short-term interest rates several times. Subprime non-banks could no longer borrow money at say 3% from Merrill and Bear and lend it out at 7% (leaving them with a 400 basis point gross profit before expenses.) When short term borrowing rates for subprime lenders shot up - and with the flood of new competitors - profit margins began to slip. Exacerbating the situation was the fact that many lenders weren't being careful when it came to loan quality. Low- or no-down payment mortgages were in as were payment option ARMs which allowed consumers four monthly choices including negative amortization: adding on to the debt they already owned. Also, Ameriquest - which appeared to be a money machine - was in trouble with the states which accused the company of abusive lending practices. In early 2006 the company agreed to pay a $325 million settlement to make the matter go away. But the bloom was off the rose.
In early 2006 there were other signs of trouble. A handful of non-banks, starting with Acoustic Home Loans of California were getting margin called by their warehouse lenders. Acoustic closed in the spring of that year. But Merrill Lynch (a lender to Acoustic) decided it wanted to own a subprime lender outright. It believed that whatever happened at Acoustic (rising delinquencies) was an isolated case and that the subprime business still showed promised - and profits. Merrill already owned a small chunk of one (Bill Dallas' Ownit Mortgage Solutions) but senior management felt that Merrill needed to lock in a steady flow of product. And what better way to do that then by owning a subprime originator.
In the fall of 2006 Merrill announced that it was coughing up $1.3 billion for subprime giant First Franklin Financial Corp. and two affiliates. Merrill wasn't the only crazy bidder out there. In total about five Street firms were vying for FFFC, including Goldman Sachs and Deutsche Bank. (Deutsche was the #3 ranked securitizer of subprime, Goldman #14.)
By this time (and even with profit margins for B&C fraying) it was apparent that most of Wall Street loved not only the business of lending money to subprime lenders and securitizing their production, but also the business of making home mortgages to credit-impaired consumers. (Who said Wall Street doesn't have a heart?)
Merrill was buying First Franklin. But they were not alone among the bluebloods and B&C funders. For years Bear Stearns had its own subprime shop: EMC Mortgage of Texas. Lehman Brothers, of course, owned Aurora Loan Services of Colorado. Morgan Stanley owned Saxon Mortgage of Virginia. Deutsche Bank owned Chapel Funding. Even Friedman Billing Ramsey, a small boutique firm based in Virginia, owned part of a subprime funder: First NLC of Florida. The whole gang was in the game.
It was a wild and crazy time in mortgage land. The idea was to finance non-banks using warehouse lines or a subprime lender outright - preferably a wholesale shop that relied on loan brokers. The last thing Wall Street wanted to do was have a retail interface with the general public, that is people with bad credit. Let the brokers deal with the garbage. With loan production secured, subprime securitizations boomed. Everyone on Wall Street was making good money. But then the bottom began to fall out. By early 2007 subprime delinquencies were rising, and home values falling. Foreclosures spiked.
By the summer of 2007 losses on CDOs by foreign investors was beginning to get coverage in The Wall Street Journal and other newspapers. The phrase 'CDO' had suddenly become part of the financial lexicon to describe what exactly was happened on the 'back-end' of the mortgage food chain (so to speak). When it came to subprime originations, the 'front-end' entailed loan brokers finding a customer and a wholesaler like Argent, Countrywide, First Franklin funding that loan at the closing table.
By the time this book went to press in mid-2008, Wall Street firms and money center banks had taken $300 billion or so in subprime-related writedowns. The ABS and CDOs they had underwritten, invested in and sold to others had to be marked down. How did it get so bad? Answer: Wall Street wasn't paying much attention to the quality of the subprime loans they were buying. Instead of re-underwriting the loans themselves Street firms like Bear and Merrill hired contract underwriting firms like The Clayton Group and Bohan to do the grunt work for them. According to rank and file underwriters that worked for these two firms, the idea was to review as many loans as possible - as quickly as possible.
There are two sides of the story when it comes to contract underwriting firms. Clayton and Bohan officials claim their contract workers did a good job of reviewing loans and that their clients on Wall Street ignored the 'grades' they gave the loans. (Under the grading system a grade of 1 meant pass, a grade of 2 meant the loan might need further review, and a 3 meant fail.) In other words, each is pointing a finger at the other. Regardless of who is responsible, two facts are certain: $300 billion in subprime-related writedowns is a financial disaster of historic proportions, right up there with the nation's S&L crisis in terms of financial damage caused to the nation. Second fact: Wall Street had left the subprime sector. Hopefully, it will never come back.
Let's recap the damage and state the obvious: subprime origination volumes were hammered in 2007 after concerns about delinquencies, credit quality, and declining home values ravished the market. According to exclusive survey figures compiled by National Mortgage News and the Mortgage Industry Directory, mortgage bankers originated $182 billion worth of subprime loans in 2007, a stunning decline of 73% from the prior year. (See tables that follow this report to view the top subprime production and servicing leaders of the past few years.)
As for the nation's top 20 subprime lenders in 2007, 14 have either closed their doors or stopped funding these risky credits entirely. Wall Street firms are no longer buying or securitizing subprime loans and more than 200 companies that once funded A- to D mortgages have either eliminated the product from their menus or shut their doors.
Countrywide Financial Corp., Calabasas, was the largest subprime originator in 2007, $16.9 billion, a 58% decline from 2006. Option One Mortgage Corp., Irvine, Calif., ranked second with $13.9 billion (down 53%); followed by First Franklin Financial Corp., San Jose, Calif. ($13.6 billion/down 51%); Wells Fargo & Co. ($13.3 billion/down 52%); and Chase Home Finance, Woodcliff Lake, N.J. ($11.4 billion/down 1%). All of these firms have exited the niche either through sale, closure or failure with the exception of Wells, which is doing only a small volume of subprime on a retail basis.
Meanwhile, the business of lending to consumers with bad credit has migrated back to "hard money" lenders who only will originate new loans if the borrower has at least 30% to 40% equity in the house. As we noted earlier, hard money lenders and consumer finance companies dominated the business in the 1960s and 1970s. Most hard money firms are backed by private investors, including hedge funds but also professionals like doctors and dentists.
But who are these firms? We've listed a few in this chapter. (See table.) One is LJL Funding of San Diego, Calif. LJL executive vice president Jeffrey Arnold notes that his firm is backed by what he calls "private investors" who are earning over 10% on their money. LJL is also a wholesaler and according to Mr. Arnold, "Our operations are heavy into technology and constant, automated notifications to our brokers regarding their file status, along with standardized and published underwriting guidelines and processes." He views LJL as a "traditional mortgage banker" working in the hard money space.
Rick Baldwin, whose family helped launch First Franklin (before it was sold to National City and then Merrill) is running a hard money lender in Lake Oswego, Oregon, called Excelsior Management Group. He told us that business is good but loan volumes are not (as might be expected) booming as they were from 2004 to 2007.
Something to consider: subprime loan volumes likely will never return to their heyday of this decade. The world has changed. The business of making mortgages (first or second liens) to people with bad credit isn't going away but it's going to be a smaller business. It very well could be a very profitable business. If LJL's investors are making 10% on their money, you can bet that other hard money firms are doing the same. Also, not all subprime funders who were in business from 2004 to 2007 have exited the space. Chase Home Finance (which is part of JPMorgan Chase) is still funding subprime mortgages as is HSBC's retail subprime division. Accredited is still alive and well. But volumes, yes, are small. One last thought: the housing and foreclosure crisis of 2007/2008 has ruined the credit histories of two million Americans, at least. Some day all these people will need loans - unless they become life-long renters.
- Paul Muolo, Executive Editor, National Mortgage News (Paul.Muolo@SourceMedia.com)
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With comments or questions about the data contact Paul Muolo, paul.muolo@sourcemedia.com For technical support, e-mail Andras Malatinszky, andras.malatinszky@sourcemedia.com For customer service, call (800) 221-1809 © 2008 SourceMedia, Inc. and National Mortgage News. All rights reserved. |
