Until recently, the home loan space was crowded with lenders offering pay-option adjustable rate mortgages, which offer low initial payments that can jump up later.

But as default rates on the risky loans rose, the lenders including now notorious names such as Countrywide, Washington Mutual and IndyMac toppled like dominoes. Indeed, Santa Monica’s FirstFed Financial Corp., which began underwriting so-called option ARMs in the early 1980s, is one of just two still standing in the country.

“It’s a little bit nerve-wracking,” said Chief Executive Babette Heimbuch. The savings and loan, which has $7.5 billion in assets, is facing a rash of problems as it struggles to avoid the same fate that befell many of its once-dominant competitors.

Last week, FirstFed reported a $245 million fourth quarter loss as the money it had to set aside to cover souring loans, called the loan loss provision, swelled to more than $200 million. Seven percent of the thrift’s $7.5 billion in assets is nonperforming. The company’s shareholder value, meanwhile, has been almost wiped out; its stock plummeted 98 percent in the past year.

Now, strapped for cash, FirstFed has been ordered by regulators to stop making loans and develop a plan to boost capital levels as it threatens to fall below the all-important “well-capitalized” threshold. If it cannot, FirstFed could be sold or liquidated by regulators.

But boosting capital in the midst of a deepening recession will be no easy task. The company is seeking investors and is considering selling off the most attractive portions of its loan portfolio.

“Time is running out for them and they’ve got to do something dramatic,” said banking consultant Bert Ely.

Second wave

Unlike the subprime mortgages that set the housing market on a downward spiral, option ARMs generally went to borrowers with good credit, though they often did not have to provide documentation to verify income.

Under the terms, borrowers received a low introductory rate and could choose between several payment options, including a minimum payment that sometimes did not even cover the interest rate. With these “negative amortization” loans, the balance rises even though the borrower makes the monthly payments a particular concern with falling home prices. The problem occurs after several years when the borrower is required to pay full interest plus principal, at which point the monthly payments can rise sharply.

Because of the delay associated with resetting rates, experts fear these kinds of loans could kick off a second wave of pain in the housing market. According to Barclays Capital, nearly half of the option ARMs originated during the height of the housing boom could go into default. Already, more than one-quarter of all option ARMs are delinquent or in foreclosure, according to mortgage data firm LPS Applied Analytics.

For two decades, FirstFed had been making option ARM loans with introductory rates near the actual interest rate. The loans had held up well, but around 2003, Heimbuch said, the thrift’s loan origination tailed off as competitors sprang up with lower teaser rates and lower monthly payment options.

Rather than simply cede market share, the company made the ill-fated decision to compete with the lenders that were offering low- or no-documentation loans.

“Competitively, in Southern California, you couldn’t make a loan that was not lower documentation, and in hindsight that was a mistake,” Heimbuch said. “The reason we started doing some lower-documentation loans towards the end of 2004 was because (otherwise) we couldn’t get a loan in the door because you had Countrywide, WaMu, Wachovia (taking that business). We tried to do low-doc loans a little smarter, but in that market, by the end of 2005, we said, ‘Oh, my gosh, you can’t do this smarter.'”

By late 2005, FirstFed believed the housing market had become overheated and the thrift started to pull back. New loan origination dropped from nearly $5 billion in 2005 to $2.2 billion the following year. But it was not until the end of 2007 that the option ARMs began resetting in large numbers.

At that time, FirstFed began reaching out to borrowers as part of a wide-scale loan-modification effort. Under the program, the company is giving borrowers a more affordable rate that does not allow the loan balance to rise.

Only about 15 percent of the participants in the program go into default, Heimbuch said, but only one in five option ARM borrowers has opted to join the program. With dwindling interest, FirstFed plans to mail out reminders to borrowers that they can have their loans modified. FirstFed has won praise from analysts for the thrift’s early recognition of problems and its efforts to correct them.

In 2009, FirstFed will have 913 option ARMs reset, down considerably from 1,741 that recast last year and 1,801 in 2007. And with interest rates at low levels, the loans will reset at more affordable levels.

However, FirstFed’s margin for error has shrunk to almost zero.

The thrift’s risk-based capital ratio, which measures the amount of cash compared with total assets, is 11.26 percent. Banks and thrifts must maintain a ratio above 10 percent to be considered “well capitalized” by regulators. A year ago, FirstFed’s ratio was more than 21 percent and it stood at nearly 16 percent as recently as third quarter 2008.

“Given the losses that they’ve been taking, they don’t have a lot of slack,” Ely said. “If they have another quarter just averaging what they lost per quarter last year, then in all likelihood they will fall out of ‘well-capitalized.'”

Extreme measures

The increasing provision for loan losses has been dragging down the thrift’s capital levels. FirstFed upped the provision to $220 million in the fourth quarter more than 10 times the amount one year prior.

With the risk-based capital ratio in danger of dropping below 10 percent, regulators issued a cease-and-desist order Jan. 26 calling on FirstFed to develop a plan to keep the company “well capitalized.” The plan, due this week, includes several drastic steps including the temporary suspension of all lending, which will shrink assets, thereby relatively increasing the capital ratio. In closing its lending operations, the company also laid off 62 employees in those divisions, amounting to 10 percent of its total staff.

But simply shrinking will not be enough, analysts said.

“(FirstFed) needs a capital infusion to remain ‘well-capitalized,'” said Paul Miller, a stock analyst with FBR Capital Markets Corp., in a research report issued last week. But, Miller added, “a capital infusion by investors will be difficult due to continued tough market conditions.”

Any money contributed to its capital account likely would be lost if the company were to be declared insolvent.

The stock market has not been kind to the company. A longtime target of short-sellers betting on the company’s decline, shares closed Feb. 5 at 74 cents, down 99 percent from a high of $69.23 per share in 2007. The company faces delisting if shares remain below $1.

Meanwhile, FirstFed must provide updates to regulators every two weeks and if the thrift cannot remain “well capitalized,” it must either liquidate or sell itself, regulators said.

To raise cash, executives are considering selling a portion of FirstFed’s $2 billion portfolio of multifamily loans, which have attractive loan-to-value ratios and no delinquencies.

“They are exceedingly good loans,” Heimbuch said. “Obviously, we don’t want to sell them. But if we needed to sell them to stay well capitalized how much would we have to sell? How small of an amount could we get away with?”

The company may be able to find a buyer for the loans, but with a portfolio already filled with poorly performing assets, FirstFed might not want to shed its best assets, Ely said.

“It might buy them some time, but what’s left is residue that’s not in very good shape,” he said. “It doesn’t save the day.”