Wall Street’s Not So Clever Subprime Acquisitions

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Last February, we questioned the wisdom of the headlong rush of Wall Street firms such as Merrill Lynch, Morgan Stanley, and Barclays to acquire subprime lenders, since it appeared that the distress in the market foretold not only a fundamental contraction but also more stringent regulation.

Our skepticism appears to have been warranted. This weekend’s Wall Street Journal featured a story, “Did Merrill, Morgan Stanley Overpay?“:

Last year, Merrill Lynch & Co. and Morgan Stanley bought subprime mortgage lenders, with Merrill paying $1.3 billion for First Franklin and Morgan Stanley acquiring Saxon Capital Inc. for $706 million.

Matthew Howlett, a mortgage-sector analyst at Fox-Pitt, Kelton, estimates that the pace of subprime lending and the volume of securities backed by such loans may fall by nearly half this year. As a result, Mr. Howlett believes Merrill may have overpaid for First Franklin by $600 million. He doesn’t believe Morgan Stanley overpaid as much for Saxon because that business includes a mortgage-servicing platform, which he believes has held more of its value.

Well, since Howlett calculations put Merrill’s overpayment at nearly 100%, it would have taken quite a lot for Morgan to have exceeded that margin. While the acquisition, plus very aggressive pricing, took Merrill from the number 4 to the number 1 position in underwriting, Howlett observed, “”I have a hard time believing it’s better than break-even.”

Another analyst concurred with the downbeat assessment:

Karen Weaver, global head of securitization research at Deutsche Bank AG, said that Merrill and other big firms are still pursuing a valid strategy of using their acquisitions to gain a supply of mortgages which they can repackage and resell to investors….

But Ms. Weaver says the business faces a “sharp and dramatic” deterioration in fundamentals, including a slowdown in home purchases and weakening home prices along with falling new mortgage and refinancing volumes. “At least 50% of the [subprime] loans done last year probably wouldn’t be done in this environment,” Ms. Weaver says.

Note that these readings are based on the current trajectory of the industry. It’s not hard to anticipate that the size of the potential market will fall and the cost of doing business will rise if (more likely when) more stringent regulation is imposed.

While Morgan Stanley officials played up the “uptick” in mortgage servicing, and said they felt it meant they hadn’t overpaid for their subprime acquisition. But that rosy view seems inconsistent with the fact that the servicer bears the cost of any renegotiation or restructuring of the underlying mortgages. And in the current climate, the regulators are pressing financial intermediaries to work out loans when feasible. Consider too that subprime defaults are rising even in a low-unemployment environment. If joblessness rises, expect lower subprime issuance and higher servicer costs as even more loans are restructured.

From the Financial Times, “Cure for subprime ills will take protracted effort“:

A rash of late payments and defaults has put dozens of subprime lenders out of business over the past six months, leaving investors nursing mounting losses and millions of borrowers unable to make their mortgage payments.

Effective debt counselling for these struggling borrowers is crucial to minimising investor losses in the huge market for securities backed by such mortgages. In this context, Mr Bernanke’s calming remarks may have understated the challenge.

Simply making contact with subprime borrowers can be one of the trickiest elements of the process, say mortgage servicers, the professional problem-solvers for troubled home loans. Up to half of subprime borrowers who fall behind on their payments are ultimately foreclosed upon without ever returning letters or phone calls.

Servicers collect payments, manage defaults, administer foreclosures and handle property sales. Encouraged by politicians and regulators, they are increasingly modifying the terms of mortgages, for example by lowering the interest rate or forgiving part of the loan – if they can track down the borrowers. They are also working with community groups to identify borrowers who, with counselling and financial help, may be able to avoid falling behind on their home loan payments.

The initiatives are sensible, but the task is Herculean. Even when the housing market is in the pink, subprime borrowers require more hands-on servicing than borrowers with better credit records.

But the slowdown in housing has dramatically increased the workload, with more than 13 per cent of subprime home loans in distress at the end of last year. The rate of serious delinquencies has also risen for some slightly less risky mortgages.

Late payments and defaults are expected to increase over the next two years as $900bn of adjustable rate mortgages – sold at low “teaser” interest rates – reset at much higher rates.

Part of the challenge is that many of the largest subprime servicers are also the largest subprime lenders. Many have already had to scale back their businesses and face losses on their mortgage portfolios; some are bankrupt.

Meanwhile, servicers report that the sheer volume of work has driven up their costs by more than 20 per cent over the past six to eight months. While servicing fees are fixed, rising defaults have forced them to hire more staff, incur higher legal fees for foreclosure proceedings and loan modifications, and cover the cost of debt counsellors who visit borrowers in their homes.

To keep track of borrowers, some servicers are presenting them with mobile phones loaded with hundreds of free minutes. Borrowers can keep the phones if the first call they make is to their lender.

If contact is made, modifying a home loan is still expensive, incurring the same kind of fees as underwriting a new mortgage – often up to $1,000 per loan. But unlike for a new mortgage, the servicer pays these fees, not the borrower.

Even when loans are modified, up to 40 per cent of the borrowers fall back into arrears within a year, prompting some concern that the strategy could be used to put off reporting problems rather than to minimise investors’ losses.

Mortgage market analysts are increasingly concerned that servicers are already unable to cope.

Mr Bernanke’s prescription may be the right one – to allow market forces to correct the problem. But the procedure will involve pain and a long convalescence.

Having read this litany of servicer activities in a workout, it’s hard to believe Morgan Stanley’s assertion that servicing has been and will be an attractive business. One has to wonder whether they are trying to fool their investors, or are merely kidding themselves.

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