The B&C Survivors ... the Envelope, Please

It's "correction time" in the subprime industry. Over the past six weeks the death knell has sounded for firms such as Harbourton, Ownit Mortgage Solutions and Sebring Capital - and those are just the ones we know of.

These mortgage bankers went under because of loan buybacks. Each company sold mortgages into the secondary market with "reps and warranties." That means should the loan go south, the secondary investor has the right to "put it back" to the primary funder. At that point the funder has few choices: buy it back outright or accept a lower price on that loan.

The lower price workout sounds easy - but it's not, especially if you're operating on razor-thin profit margins and your shop has little in the way of available cash.

Let's say "Vincent Mortgage" sells a $100 million pool to Merrill Lynch at say 101.5. (Par is 100). (I pick Vincent Mortgage because I had an uncle Vinny who, in the old days, got overextended with some, shall we say, non-licensed lenders.) Merrill then says, "Great, sounds good, Vinny." Then, 60 days into the life of these loans early payment defaults begin to pile up and Merrill says, "Hey Vinny please buy back the pool, all $100 million."

Vinny Mortgage then says, "I really can't and don't want to do that, Mr. High Powered Investment Banker." Merrill then says, "Remember I'm also your main source of warehouse money. Either buy them back or I'm closing you down. Of course there's another solution, Vinny. We can renegotiate that 101.5 purchase price to 98 and you give me some money." Now, depending on how much money Vinny has, it might do that. But like I said, these are tough times for subprime lenders.

Many firms - including the ones I mentioned earlier - are choosing to close their doors instead of pay the piper. The reason they can't pay the piper is simple: they don't have the money, at least not that kind of money.

I use Merrill as the foil in my example because it's a well-known warehouse funder and buyer of loans from non-depository subprime firms such as Ownit. In fact the scenario I laid out with Vincent Mortgage (sort of) happened to Ownit and its warehouse provider, which was, you got it, Merrill.

Now, I'm not blaming Merrill Lynch. I know it sounds like I am, but hey, Merrill has rights, too. The strange thing about what transpired between Merrill and Ownit is that Ownit's demise only helps First Franklin Financial Corp., a subprime funder that Merrill recently ponied up $1 billion for. (The $1 billion price tag included a servicing shop and affiliated assets.)

Merrill also is a warehouse lender to Mortgage Lenders Network, which in December closed its wholesale network, a platform that accounts for 90% of its production. (MLN services about $17 billion in product.)

Any student of business knows that less lenders means less competition and that, in theory, should be good for the subprime sector's survivors. And just who will survive the current carnage, which likely won't end until June? Two factors will determine the winners: cash and good management.

Cash will be needed to fund buybacks. Cash will be needed to work out bad loans. Cash will be needed to fix systems and underwriting guidelines and smack upside the head those loan brokers responsible for the bad loans. It will take good management to make these things happen.

By the way, I don't subscribe to the belief that banks and Wall Street firms will be the victors in this bloodletting. In the short term, yes, they will do fine, but longer term, banking regulators are going to make it difficult for depositories to be aggressive in the subprime market.

As the nonprime industry evolves and new (untested) loans hit the market, I would venture that the innovators will be non-depositories using warehouse lines of credit. Look for private-equity firms to get involved, too. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com