Sunday, January 28, 2007
Subprime's grip slips
O.C. lenders pay a price as more homeowners miss payments on risky loans.
By MATHEW PADILLA
The Orange County Register
Many of Orange County's boldest lenders are struggling to stay in the black – and in some cases to stay in business – as their customers miss mortgage payments in record numbers.
These lenders, experts say, exercised poor judgment in a bid to maintain loan volume last year. They lent money to borrowers with spotty credit, known as the subprime market, without proper regard to their ability to repay, experts say.
"What's become clear is a whole bunch of people signed up for loans or were sold a loan they really couldn't afford," said Richard Eckert, an analyst with Roth Capital Partners in Newport Beach.
Sluggish home prices, rising interest rates and lax underwriting spurred defaults on subprime loans made just last year to the highest level in six years.
Perhaps most troubling, loans made by Orange County companies in 2006 were among the quickest to see defaults, data show.
And many of those subprime companies – which tend to cluster here in Orange County – are in trouble.
H&R Block's Option One in Irvine is up for sale. So is Ameriquest Mortgage in Orange. ECC Capital of Irvine is selling its loan-making operations to New York's Bear Stearns Cos., although the sale has been delayed.
UBS Investment Bank, the London-based unit of Switzerland's largest bank, UBS AG, analyzed subprime mortgages made in 2006 and found that borrowers were missing payments on loans made that same year at the highest rate since 2000.
In fact, UBS found subprime loans made in 2006 are on track to be the worst-performing loans ever issued.
Brea-based Fremont Investment & Loan, a unit of Santa Monica's Fremont General Corp.,topped UBS' list of poor performing loans. By late last year, 7.26 percent of Fremont's subprime loans made that same year were 60 days or more delinquent.
Argent, a unit of ACC Capital in Orange, which also owns Ameriquest, scored high on the list with a delinquency rate of 5.86 percent.
Option One landed closer to the middle with a 4.54 percent delinquency rate, and Irvine's New Century Financial Corp. had a 4.33 percent default rate.
So what went wrong, exactly?
Lenders made two mistakes, according to UBS and other analysts.
They didn't scrutinize borrowers' incomes, and they allowed subprime borrowers, who by definition have had past problems with their credit, to take on lots of risk.
Borrowers took advantage of "stated income" loan programs, where they simply tell lenders what they earn, said David Liu, director of UBS' mortgage strategy group.
And many first-time homebuyers made a small down payment or none at all. Often they took out simultaneous second mortgages to avoid paying mortgage insurance.
Borrowers gambled on rising home prices to bail them out of trouble, analysts said. Consumers thought home prices would keep climbing, which would enable them to sell or refinance if they got into a jam, analysts said.
But stalling or falling home prices last year changed all that, UBS' Liu said. Borrowers quickly began to miss payments.
"They lost the motivation or incentive to send in the checks," Liu said.
Because of the way loans are ultimately funded, it's very costly for lenders when a borrower misses one of the first payments on a loan.
Lenders package loans in big pools and sell them as bonds to investors. If a borrower misses the first payment, an investment bank putting the whole deal together can compel the lender to buy back the loan.
Lenders typically lose a lot of money when they must buy back delinquent loans. They lose transaction costs and may sell the loan again at a loss. Often when a borrower has defaulted, there is little or no equity in the home, so a foreclosure sale will not cover costs.
And there's another issue for subprime lenders who make newer, more exotic loan types.
Government pressure is building against the widespread use of loans in which a borrower pays only interest for a time or has the option of making a minimum payment that results in added debt.
Five federal agencies proposed guidelines on such loans in September, saying lenders need to better consider a borrower's ability to repay. The agencies said lenders are layering too much risk onto borrowers, especially consumers getting subprime loans.
And perhaps worst of all for lenders, investors and bond-rating agencies are closely watching loan performance. If loans start going bad, rating agencies will downgrade bonds and, thus, investors will pay less for them.
Fremont, whose loan delinquencies have spiked, recently adopted stricter guidelines for the second time in a year, according to Bloomberg News, which obtained a company memo on the topic.
Trude Tsujimoto, general counsel for Fremont, declined to comment on the memo or the Bloomberg story, which said the company will stop loaning to consumers who can't prove their income when buying a home with no money down.
"Our process is we are always looking at market conditions," Tsujimoto said in a telephone interview. "We are always tweaking our underwriting guidelines. This is another round of changes that we make periodically."
Tsujimoto, however, acknowledged the industrywide spike in defaults. Given the market environment today, it's prudent to have more restrictive guidelines, she said.
New Century Financial has been more public about changing its underwriting and ensuring that consumers know the risks of certain loan types.
In October, the company said it would look at a borrower's ability to repay after the end of low initial terms on adjustable-rate mortgages.
It stopped shy of saying it would consider a borrower's ability to repay the loan at its fully indexed rate, which is the maximum rate a borrower is likely to pay based on a moving index. The company said it would look at the fully indexed rate minus 1 percent.
Like Fremont, New Century has taken further steps to make its underwriting more restrictive, according to the company.
Several of the new rules affect first-time buyers. New Century won't lend them money if they don't plan to live in the property they're buying.
And if first-time buyers are putting less than 10 percent down with a "stated income" loan, they need to have savings equal to six months worth of mortgage payments.
Tony Meola, executive vice president with loan production at New Century, said the company is acting more from a sense of prudent lending than from pressure by government agencies or investors in its mortgages.
"We have no interest in putting people in homes that they can't afford," Meola said. "We have the responsibility to lend appropriately."
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