The once high-flying home mortgage industry is under siege and perhaps nowhere more so than the greater Los Angeles area.
While major subprime lenders like Fremont General Corp. and New Century Financial Corp. have grabbed the headlines in recent weeks, the fallout from the troubles in the subprime lending sector is threatening the entire home loan industry and with it, one of the pillars of the region’s economy.
Subprime lenders have announced wave after wave of layoffs for weeks in the most direct impact. In the last month alone, three of L.A. County’s largest subprime lenders
Lending: Crisis Built as Home Prices Sagged
The once high-flying home mortgage industry is under siege and perhaps nowhere more so than the greater Los Angeles area.
While major subprime lenders like Fremont General Corp. and New Century Financial Corp. have grabbed the headlines in recent weeks, the fallout from the troubles in the subprime lending sector is threatening the entire home loan industry and with it, one of the pillars of the region’s economy.
Subprime lenders have announced wave after wave of layoffs for weeks in the most direct impact. In the last month alone, three of L.A. County’s largest subprime lenders
Calabasas-based Countrywide Financial Corp., Santa Monica-based Fremont and Burbank-based WMC Mortgage Co., a unit of General Electric Corp. have cut more than 1,000 jobs.
But beyond that, should the problems start to spread to the so-called Alt-A market, that huge pool of borrowers between the subprime and prime market, another major lender also could be in trouble: Pasadena-based IndyMac Bancorp. And if Countrywide, the nation’s largest Alt-A lender, decides to cut back on them, the larger lending industry could be impacted. SBMC Mortgage Co., a Van Nuys-based unit of Kennington Ltd. Inc. and a smaller Alt-A player, could also be at risk.
“The entire mortgage industry is at risk,” said Esmael Adibi, director of the Center for Economic Research at Chapman University in Orange.
For now, all industry eyes are on the delinquency rate for Alt-A loans. The rate for loans more than 60 days past due on payments has doubled in the last 14 months to 2.4 percent, according to UBS AG. While that’s still much lower than the 13 percent delinquency rate for subprime loans, if it goes much higher, the financial institutions and investors that have purchased these loans are likely to stop their purchases, causing the same problems now wracking the subprime sector.
That would pose a particular problem for Los Angeles and Southern California.
“Alt-A loans are more prevalent in Southern California than almost anywhere else,” said Zach Gast, an analyst with the Center for Financial Research and Analysis in Bethesda, Md.
Subprime central
The fallout from the subprime meltdown is already hitting the Southern California area harder than almost any other region in the country. Not only is the area home to some of the highest concentrations of non-prime loans as housing prices have soared out of reach for most residents, but it’s also the center of the universe for the subprime industry itself.
It’s an industry that got its start in the mid-1990s as giant lenders like Countrywide began to seek out customers with less-than-perfect credit records (generally under 640 on the Fair Isaac Co. scale) and charge higher-than-standard interest rates.
“It started as a way to make housing more affordable and to increase home ownership. It was a huge untapped market,” said Bob Visini, spokesman for First American LoanPerformance, a loan tracking firm.
Of course, there is a risk in extending loans to people with spotty incomes or credit records: they are more likely to be unable or unwilling to pay back the loans. That’s why the interest rates on these loans are higher a feature that lured many lenders into the business.
Southern California, in particular, became the center of the industry for two reasons. By the late 1990s, it was a huge market with home prices much higher than in other parts of the country, which meant that people with modest incomes had to stretch to buy a home, according to Yongheng Deng, associate professor of policy, planning and development at the University of Southern California.
Also, there was already a substantial mortgage loan infrastructure here. There were giant lenders such as Countrywide and Ameriquest (a subsidiary of Orange-based ACC Capital Holdings), as well as a huge network of mortgage brokers trying to match up prospective home buyers with financing.
Four forces converged to fuel this burgeoning subprime market in the late 1990s and the early years of this decade: historically low interest rates, rapid home price appreciation, greater acceptance of non-traditional loan products such as interest-only loans and loans with low introductory or “teaser” rates, and an increasing investor appetite for mortgage-backed securities.
The most important of these factors was home prices, which from 2001 through 2005 increased 20 percent annually in Southern California. With home prices skyrocketing, borrowers could use their ever-increasing home equity to refinance their mortgages or sell at a profit.
“As long as home prices were increasing, it masked the risks inherent in these types of loans,” said Chris Thornberg, principal with Beacon Economics in Los Angeles.
What’s more, brokers and loan originators had powerful incentives to market non-prime loans. Brokers received refunds from loan originators such as New Century every time they made a non-prime loan. And the loan originators could package the loans and sell them in a matter of weeks or months to investors, thus ridding themselves of long-term liabilities. This freed them to loosen their underwriting criteria.
Eventually, the whole subprime frenzy fed on itself and spun out of control. Subprime loan originators, who depended on huge volumes of loans to resell to investors, reached deeper and deeper into the ranks of people with questionable credit to keep the volume of loans up. And because so many people were able to get loans to buy homes, that in turn drove much of the increase in home prices, especially in 2005.
Of course, last year, when housing prices flattened in L.A. and across the nation, the whole premise of subprime loans began to unravel. Borrowers could no longer tap increasing equity in their home to refinance risky loans at less costly terms, nor could they sell easily.
But while everybody expected an increase in delinquencies, something happened that most subprime lenders didn’t bet on: subprime borrowers began missing their initial payments. And that spelled disastrous consequences because of buyback clauses.
“If the borrower misses one of the first three payments on the loan, then the lender has to buy back the loan” from the investors who purchased them, Gast said. “That’s the industry standard.”
This happened with growing frequency through 2006. For example, Fremont General paid $238 million in the second quarter of 2006 to buy back loans, up from $67 million in the same period the previous year.
To offset this, many lenders furiously tried to sign up even more borrowers. But here, too, there were difficulties: By the end of 2006, investors were shying away from buying mortgage-backed securities, further exacerbating cash flow problems at subprime lenders.
The first casualty in Los Angeles came last April as Acoustic Home Loans LLC, the subprime lending unit of Sherman Oaks-based Metrocities Mortgage Corp., ceased operations. That was followed in early December by the closure of Agoura Hills-based Ownit Mortgage, which employed 800 nationwide, with 300 workers in California. In a statement, Ownit blamed Merrill Lynch & Co., saying the investment giant had cut off funding; Merrill publicly disputed that claim.
Some other companies, including Countrywide, began to scale back their subprime lending operations. Countrywide laid off 2,500 employees in the fourth quarter.
Since then, the subprime mortgage industry has imploded, with virtually every lender large and small coming under intense pressure, most recently from state and federal regulators.
Fremont announced March 2 that it had received a “cease and desist” order from the Federal Deposit Insurance Commission for risky loans. Three days later, the company announced it was exiting the subprime business and that it had put an unspecified number of the 2,400 employees in its subprime unit on paid leave.
The company did get a reprieve when Credit Suisse Group agreed on March 12 to extend a $1 billion line of credit. And on March 21, Fremont announced it had arranged to sell $4 billion of its loan portfolio to undisclosed buyers over the next several weeks for a higher-than-expected 96 cents on the dollar. These two announcements caused Fremont’s stock to rebound to $10 a share from a low of $5.55 a share in early March.
As of last week, Irvine-based New Century Financial was hovering on the brink of total collapse. Its credit lines had been cut off, its stock had been delisted from the New York Stock Exchange and it was under investigation from the Securities and Exchange Commission and other federal regulators for alleged accounting and market violations. Last week, regulators in several states ordered New Century to stop making subprime loans. The company has laid off 500 employees in the last two months.
Although only 7 percent of its home loan portfolio is in the subprime market, Countrywide’s huge volume of subprime loans forced it to announce an additional 108 layoffs this month. And WMC Mortgage has laid off 460 people, roughly 20 percent of its workforce.
The impact of the contraction in the subprime industry is likely to extend beyond the major lenders. First in the crosshairs are likely to be smaller mortgage loan companies in the L.A. area that package loans to sell to the giant residential lenders. These include companies such as Irvine-based New Day Trust Mortgage Partners.
The next to be hit will likely be in the ranks of thousands of mortgage brokers, followed by real estate agents.
So far, brokers are holding their own, since most also arrange loans for prime borrowers, said Allen Jackson, vice president of Bristol Home Loans, a Bellflower mortgage brokerage.
“I’ve been doing this for 30 years and have learned that you just have to adjust to the market,” Jackson said. “You must search out those clients who can qualify for loans.”
So far, a mediating effect on all this is the low unemployment rate nationwide and especially here in Southern California.
Also cushioning the blow is the fact that people who took out non-prime or adjustable rate loans three or four years ago did see a jump in the equity value of their homes and used that to refinance into 30-year fixed loans, essentially avoiding the high-payment trap that more recent borrowers now find themselves in. Many economic observers believe this could contain the damage from the subprime meltdown.
But others say the economic impact could broaden, especially if the Alt-A market goes the way of the subprime sector.
Not only would larger numbers of homeowners face upside-down mortgages, but even those able to make their payments may no longer be able to refinance to draw money out for remodeling, car purchases and the like. In essence, the ability of consumers to use their home equity as a giant piggy bank may be nearing an end.
“That’s when this lending crisis will hit the general economy,” Adibi said.
