In the end, this much is certain about the demise of Fremont General Corp.’s subprime lending business: executives moved far too slow as the risky market went south faster than anticipated.

The company’s Fremont Investment & Loan industrial bank was still making subprime residential mortgages last week, just two days before federal regulators moved in with a cease and desist order and the ailing subprime unit was put on the market.

It was a reflection of what some say was a weak effort to stem growing losses, beginning in 2005 when the bank cut back on interest-only loans amid signs the national housing market was beginning to slide.

“With home prices going up 10 to 15 percent a year, it didn’t matter who the borrower was because either the collateral would bail you out, or the borrower would sell the home,” said Scott Valentin, consumer finance industry analyst at Freidman Billings Ramsey & Co. Inc. “But once home prices slowed down, owners didn’t have the equity to refinance or sell it out of delinquency.”

Fremont originated $33 billion in subprime loans last year, the fifth largest such originator in the country. Fremont made only subprime mortgage loans, although it also makes commercial loans. Fremont executives would not comment.

Given the company’s history of running a previous unit into the ground a failed worker’s compensation business that was taken over by the state Fremont’s latest travails have a tinge of deja vu.

When the Federal Deposit Insurance Corp. last week issued its cease-and-desist order, it cited weak risk management by Fremont Investment & Loan in its residential mortgage and commercial lending units. In 2003, Fremont Indemnity Co. was among 27 workers comp insurers that either were taken over by the state or went out of business starting in the late 1990s as lax underwriting standards and weak risk management left insufficient revenue to cover claims.

Last week’s news triggered inevitable comparisons of Fremont General’s handling of the two business units, both of which unraveled as heated competition for customers in their respective industries led many underwriters to lower their standards. That’s especially so as evidence grows that Fremont continued to make risky subprime loans even as defaults grew.

“I’m disappointed but not surprised you’d think they would have been a little more cautious this time,” said Tom Welsh, outside counsel for the California Department of Insurance, which has been attempting to get compensation for tax credits Fremont General kept after the state assumed responsibility for the insurance subsidiary.

New direction

After Fremont decided to exit the workers comp market in 2001 two years before the unit was taken over it turned to residential and commercial lending as the next big hope for satisfying Wall Street’s growth expectations.

By 2002, that strategy appeared to be paying off, with the company reporting a 91 percent gain in net income in the third quarter. Fremont, which has residential mortgage operations in 47 states, not only rode the wave of California’s housing boom but specialized in one of its most lucrative sectors.

Subprime mortgages typically featuring low introductory interest rates and small to no down payments target consumers unable to qualify for conventional loans because of credit, income or documentation problems. The products had appeal because rapid appreciation of California home values theoretically would enable homeowners to refinance before the teaser rate ended.

Fremont’s business model sought to limit liability and increase profits by selling the mortgages in packages to such investment banks as Deutsche Bank and Goldman Sachs for repackaging as mortgage-backed securities. The company also created its own securities via a special-purpose entity. In many cases, the company continued to generate cash flow from the sold mortgages because of fees it charged for servicing the loans.

But by mid-2005, the subprime market had already peaked. That tempted many lenders to loosen standards to maintain origination growth rates. Slowing home appreciation the following year caught up with homeowners whose monthly payments were poised to increase sharply.

Fremont had bragged that it skimmed off the upper crust of the subprime base borrowers with only minor credit problems and the self-employed who often have problems documenting income. But by early last year it was clear from regulatory filings that the company was setting aside more money to deal with increasing defaults.

The company in late 2005 had already cut back on interest-only loans. In the second quarter of 2006 it further tightened up. It eliminated certain loan products for people with lower credit scores and no longer allowed loan amounts to be as close to the home’s assessed value.

Temporary improvement

By its third quarter financial report, Fremont said it was seeing a positive impact from the tougher standards, and expected the improvement to be reflected in its first quarter financials this year. But accelerating deterioration in the overall subprime market as the national housing market failed to rebound outpaced Fremont’s efforts.

Loan repurchases and re-pricings short-term guarantees to investors in case a loan defaults in the first few months rose 45 percent in the third quarter of 2006 from the previous quarter, a trend that many of the company’s competitors were seeing on an even larger scale

In addition, investors weren’t willing to pay as much for Fremont’s subprime paper as they once did. The company went from reporting an $8.4 million gain on loan sales of $9.9 billion in the second quarter to a $9.6 million loss on sales on $8.2 billion in the third.

The company still went ahead with expanding loan servicing operations by opening an office in suburban Dallas in the fall. But by January it cut ties with 8,000 third-party mortgage brokers it said had originated many of the company’s riskiest loans.

FDIC records indicate that Fremont’s non-current loans those exceeding 90 days in arrears sharply grew to more than $188 million last year from $45 million in 2005.

Then on Feb. 28, the company told Wall Street it was delaying its fourth quarter financial report, which triggered a nearly week-long sell off in the stock. Two days later it announced it was selling off the subprime residential unit, which had served as a counterbalance to the commercial loan business, which focuses on construction and bridge loans for condominium and mix-use projects. Some investors noted a sale will leave the company less diversified.

“Fremont isn’t like a New Century or Novastar Financial that only does subprime,” said Theodore Kovaleff at Sky Capital LLC, who owns Fremont shares and has monitored the company since its workers comp days. “They have a valuable diversity they’re going to lose if they sell the mortgage business. But maybe they think that with the increased regulatory scrutiny, the opportunities are no longer there.”

Fremont’s decision to exit the subprime mortgage market came despite an apparent willingness by regulators to work with the Santa Monica bank to upgrade its practices, according to FDIC sources. Other analysts theorize that the company learned from its past experiences by this time bailing out of a failing business while it still had value.

The head of the mortgage unit last week told his employees, who are on paid leave, that the company was in discussions with as many as six potential buyers. That level of interest doesn’t surprise Valentin at Freidman Billings, who expects much of the interest is coming from the same investment banks that now buy Fremont’s mortgages.

“Wall Street wants assets like this because it gives them pipeline, and in cases like this, probably for pennies on the dollar,” said Valentin, who doesn’t own Fremont shares.

“Subprime was 25 percent of originations last year (in the mortgage industry as a whole). Maybe it goes down to 15 percent this year, but it isn’t going away.”