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Battered home-loan industry gets boost from big investors

Battered home-loan industry gets boost from big investors

Private equity, hedge funds and investment banks are all jumping into the subprime-mortgage business, which has been plagued by decreased volume and rising defaults. "There is a lot of money pent up," said Steve Probst, national sales manager with Fairway Independent Mortgage. "And a lot of people are betting that the market will snap back quickly."

Big Investors Jumping Back Into Shaky Home Loans
By VIKAS BAJAJ and JULIE CRESWELL

The subprime mortgage business is in tatters: loan volume is plummeting, defaults are rising and some of the biggest lenders have cut back or shut down.

So what is the smart money — private equity, hedge funds and investment banks — doing? They are swooping in and taking over those battered businesses, seeing opportunity amid the wreckage.

“There is a lot of money pent up,” said Steve Probst, national sales manager with Fairway Independent Mortgage, a lender based in Sun Prairie, Wis. “And a lot of people are betting that the market will snap back quickly.”

It is a risky proposition.

In many parts of the country, there is a glut of unsold homes. Defaults and foreclosures are rising, putting further pressure on home prices and mortgage lending. Some housing industry officials worry that the new infusion of capital may refuel aggressive and risky lending to people with poor credit, known as subprime borrowers, delaying a much needed winnowing of the business.

Those dark clouds do not faze the new money in subprime. Among those making the biggest bets is Cerberus Capital Management, which first made its name investing in distressed debt. One of the country’s largest private equity firms, Cerberus has a record of making risky contrarian bets, including its recent agreement to take control of the troubled Chrysler Corporation for $7.4 billion.

Cerberus acquired control of the subprime lender Residential Capital last year, when it led an investment consortium that bought a 51 percent stake in G.M.A.C., the finance arm of General Motors. And in April, Cerberus, which also owns Aegis Mortgage, a subprime lender based in Houston, announced plans to acquire Option One, the troubled mortgage subsidiary of H&R Block.

Taken together, these acquisitions would make Cerberus the biggest subprime lender in the country, far ahead of large mortgage giants like Countrywide, Wells Fargo and others, according to first-quarter lending statistics from Inside Mortgage Finance.

It is unclear whether Cerberus will combine its mortgage operations into one company or operate them autonomously. Consolidating the businesses would offer streamlining and cost-cutting advantages, analysts say. Executives at Cerberus, which closely guards details about its strategy and investments, declined to be interviewed for this article and did not respond to written questions.

“They have certainly double-downed and have bought some extremely attractive operations — companies that have dominated their space,” said Brenda B. White, a managing director with Deloitte & Touche Corporate Finance. “But now they’re faced with executing on a plan, whatever that plan might be.”

This year, when rising mortgage defaults and a credit squeeze on Wall Street have forced many subprime mortgage companies into bankruptcy, some analysts predict that the industry might shrink by a third or more. Many industry officials acknowledged that a shakeout was necessary to cull the industry of the lenders that led in making risky loans and forcing rivals to match them or lose business.

In the last several months, however, private equity firms and others have acquired, taken stakes in or provided fresh capital to companies that wrote nearly 20 percent of last year’s $600 billion in subprime loans. It is, analysts and industry officials suggest, an unusually quick and substantial bet on a distressed business that by most indications is in the early phases of a long-term retrenchment.

With billions in capital available to them, investors like Cerberus, Ellington Capital and the Citadel Investment Group see an ideal buying opportunity. Yet trying to time the bottom of a sliding market has been tricky, even for smart-money investors like Cerberus. For instance, rising defaults and the cost of buying back poorly performing loans from investors left Residential Capital with more than $1.5 billion in losses in the six months that ended in March and the losses are expected to continue. (In March, General Motors, which still owns 49 percent of G.M.A.C., was forced to put an additional $1 billion into the unit because of the division’s mortgage woes.)

Cerberus has insisted on a number of terms and conditions in its deal to buy Option One, suggesting that the firm has become more vigilant about not paying too much. As announced, Cerberus agreed to pay slightly less than $1 billion, but the final amount could range from as little as $400 million to $800 million, depending on how well Option One’s business fares from now to the transaction’s closing in October, according to estimates prepared by Kelly Flynn, an analyst with UBS.

That is a far cry from the $1.3 billion H&R Block executives said earlier this year that they expected to get for the unit. H&R Block could get more money from Cerberus if Option One turns a profit within 18 months after the deal closes. Barrett Burns, who has run lending businesses for Citibank and Ford Credit, says that Cerberus and the other investors in the mortgage business are being far more prudent in their purchases than big Wall Street firms like Merrill Lynch and Morgan Stanley were when they paid hundreds of millions of dollars for subprime companies last year.

“The investment banks that were buying last year were buying at the high,” said Mr. Burns, who is now chief executive of Vantage Score, a company that provides credit scores that lenders use to evaluate borrowers.

(Both Merrill and Morgan have said they are comfortable with what they paid for their subprime acquisitions.)

Astute buyers, Mr. Burns noted, are picking up loan servicing businesses, which earn a predictable stream of fees for handling collections and dealing with defaults, and retail branch networks, which are difficult to build and tend to produce better-quality loans than wholesale channels like mortgage brokers.

Even so, industry officials say new entrants to the subprime business may be in for nasty surprises if they think the current difficult stretch represents a bottom. Making money in the business, they say, is difficult and getting harder.

Investors who buy subprime mortgages are demanding higher-quality loans after being burned by high rates of defaults and fraud in loans written during 2005 and 2006. That is forcing mortgage companies to tighten lending standards by demanding that borrowers make bigger down payments and have better credit histories, changes that have significantly reduced the pool of qualified borrowers.

“The reality is that the mortgage business for the foreseeable future is not a growth business,” said Jeffrey Kirsch, president of American Residential Equities, which buys defaulted mortgages. “So, it is surprising to see things frankly where they are.”

Mr. Kirsch and others say buyers like Cerberus will have to be willing to lose money and invest in the companies they are acquiring for some time before things pick up.

“They’re taking enormous risks here in hoping that they’ll be able to stabilize these businesses, keep them going, and get the types of regulatory approval they need to originate and service mortgages,” said Rick Antonoff, a partner in the bankruptcy and restructuring practice at the law firm of Pillsbury Winthrop Shaw Pittman. “They have put a lot of capital in already, and it’s going to take additional capital to keep these businesses going for a while.”

Those concerns are a major reason other subprime lenders have not succeeded at selling assets. New Century Financial, which was one of the biggest subprime lenders in the nation before it filed for bankruptcy protection in April, failed to attract bids for its loan origination unit in a bankruptcy auction because regulators in several states including California had restricted it from making more loans. (Cerberus had briefly considered acquiring New Century before it filed for bankruptcy, according to industry officials who asked not to be identified because they were not authorized to speak about the matter.)

In other instances, investors have put more capital into subprime after securing concessions that would have been unthinkable even six months ago.

In April, Accredited Home Lender, a San Diego-based lender, raised $230 million in loans from Farallon Capital, an investment firm based in San Francisco. The mortgage company agreed to pay a 13 percent interest rate and penalties if it sought to pay off the debt ahead of time. The company also gave Farallon warrants that would allow it to increase its stake in Accredited to 19 percent, from 7 percent. The warrants allow Farallon to buy the company’s shares for $10 apiece, a discount to the stock’s $13.99 closing price yesterday.

Another hedge fund, Second Curve Capital, that bought an 8.5 percent stake in Accredited in early February when the stock was trading at $25 to $30, has increased its stake in the company to 11.2 percent as the stock has fallen.

Citadel, an aspiring financial conglomerate based in Chicago, picked up the lending business of ResMae for just $22 million. Ellington Management, a hedge fund based in Greenwich, Conn., that specializes in mortgage-backed securities, has agreed to pay an undisclosed sum for the lending business of Fremont General, which has not made a subprime loan in almost three months and has cut 2,400 jobs in its lending business.

It is unclear how these investors will operate their new subprime businesses — most declined to discuss their plans or did not return calls for comment — but at least one mortgage company said it was concerned about lending standards weakening again.

“There is a lot of fear that expansion starts again because liquidity is coming in,” said Stephanie Christie, a senior vice president in charge of nonprime lending at Wells Fargo Home Mortgage. “The industry needs to be very serious about prudent underwriting and make sure we don’t go back to making bad loans.”

At the same time, however, analysts note that the new capital could help alleviate the credit squeeze many regulators and housing advocates feared would impede borrowers who want to buy homes or need to refinance out of onerous mortgages.

“No one wants to see subprime lending dry up altogether,” said Kathleen Shanley, an analyst with Gimme Credit, a research firm, “because of the potential implications for growth in the housing market and the hardship for existing borrowers who may need to refinance their loans.”

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mortgages, subprime, investment banking, private equity

Labels: investment banking, mortgages, private equity, subprime

posted by Victor Lloyd Smith @ 4:21 PM