Fremont's Strategic Shift Yields Profits But Older Debts Loom

By RiSHAWN BIDDLE
Staff Reporter

Fremont General Corp.'s transition from workers' compensation insurer to real estate lender is finally leading to profits. Yet its heavy debt load and liabilities from its old business still leave it at risk if the economy worsens.

Last week, shares in the Santa Monica-based firm hit a new 52-week high of $7.59; the stock has gained 52 percent since the beginning of the year and more than doubled over the past year.

The gains have coincided with the company's decision to abandon its swooning workers' compensation business. Once the second-largest private underwriter in California, Fremont General now focuses on subprime lending and commercial real estate lending. While the company reported a 56 percent decline in net income last year, to $26 million, income from these businesses nearly doubled to $53 million.

Subprime has been a growth driver for the company, which originates the loans, then sells them off for cash. It doubled the number of residential loans written last year to $6.6 billion, selling off $5.7 billion of them to institutional investors.

Chief Financial Officer Wayne Bailey said in a conference call last month that the company expects to boost the number of loans it originates to the "$9-to-$10 billion range, again."

But Wall Street hasn't taken notice. With its exit from workers' compensation, Fremont lost coverage from Merrill Lynch and debt-ratings agency Standard & Poor's. One company still following Fremont, Egan-Jones Ratings Inc., recently raised its rating on the company's senior debt from C to CCC+. But the firm said "risks remain."

One problem remains the workers' compensation unit, which it shut down in 2001 after a $541 million loss and sold to Employers Insurance Co. of Nevada last year.

Fremont is still responsible for policies it already issued, although it has effectively given up their control to state regulators. The assets and liabilities of those policies are no longer carried on the balance sheet, but their administration still affects the company's ledger.

Last year, Fremont reached an agreement with California's Department of Insurance to contribute $79.5 million over six years to keep the policies afloat. It took a $77.8 million charge against earnings related to the business. "Hopefully the insurance operation does not require significantly more cash or capital," Egan-Jones said in its February report.

Fremont officials, who were traveling last week, couldn't be reached for comment.

Fremont's lending businesses are vulnerable as well. Growth in its subprime business has come as more homeowners with less-than-perfect credit scores have taken out loans to take advantage of low interest rates. But Egan-Jones expects that home refinancings will slow, reducing the fee and interest income Fremont generates.

Another challenge may come with selling off the loans: Last year, Fremont sold 60 percent of its loans to just two financial institutions, according to its 10K filing. If those investors stop buying the loans, the company says it could be "adversely affected." Fremont would then be forced to carry the loans on its balance sheet, increasing its risk exposure.

In the late 1990s, a number of subprime lenders went out of business after the hedge funds that were buying their loans stopped doing so. Charges of predatory lending by banking regulators have scared off some investors as well.

Fremont has pared back its debt by $165 million over the past two years, but still has $1.5 billion outstanding.

Debt coverage hasn't been a problem because the company has generated more than enough cash to cover its payments, said Robert Robotti, president and managing director of Robotti & Co.

"But if things go bad on the subprime and commercial lending sides of the business, that can change," he added.

The economic slowdown hasn't helped Fremont's commercial lending business, which specializes in providing bridge financing for renovation projects and construction loans. Originations fell slightly to $1.78 billion last year. While the number of "charge-offs" of bad loans is less than 1 percent of its total portfolio, it has grown four-fold in the last year. In anticipation of additional loan losses, Fremont doubled its provisions to $108 million.

Unlike most banks, Fremont only lends money on real estate projects through a network of 5,000 brokers. Without a direct relationship with its borrowers, the company could have a more difficult time recovering its money.

"Your average bank has leverage over a borrower such as his personal loans or mortgages. There's a relationship that a borrower doesn't want to ruin. But Fremont doesn't have that kind of leverage," said David Spring of rating agency Fitch Inc.

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