(1) All subprime lenders recycle their money by selling loan pools in the secondary market (except for lenders owned by institutions with portfolios - e.g banks (deposit portfolios), REITs, Fixed Income funds etc).
(2) The process of selling loan pools backed by Fannie, Freddie is a fairly well structured "cookie-cutter" process (note that recently Freddie has extending its backing to the upper levels of subprime, aka near-prime loans).
(3) The process of selling loan pools outside of (2) is more involved in process specific to the pool and not as "cookie-cutter". Typically, the pool is protected for default risk e.g by overcollaterizing it, by obtaining Mortgage Pool Insurance (which typically insures for default from upto 10% to 25% of the portfolio), seasoning the loans (i.e making sure that the loans have a history of payments for a few months before they are included in the pool), having strong loan servicing/collections practices that reduces delinquency etc). It can then rated by a bond rating agency e.g Moody's. It is the offered for sale to investors. Each sale can be an event, with specific conditions & guarantees offered to investors depending on the loan pool.
(4) Another point to note is that typically, the subprime lenders have their own Loan Servicing/Collections units and the loan pools are sold Servicing-Retained (i.e their units service the loans). All operational aspects of Loan Servicing & Collections e.g payment processing, managing the default/delinquency rates, investor reporting, foreclosure processing etc is done by these units.
(5) This recent Forbes article on ABFS is illustrative of what can go wrong if some of these assumptions go awry. (I have pasted that below). Once a lender gets a reputation for non-performance of their loan pools, the investors tend to stay awway from them.
forbes.com
Subprime Spiral
Rob Wherry, 01.28.04, 11:59 AM ET
Next week, time runs out on a stock deal between Philadelphia-based American Business Financial Services, a sub-prime mortgage originator, and some of the holders of $700 million worth of the company's unsecured notes. The company wants to convert $200 million of those notes into a mix of preferred stock and collateralized debt.
That would help ABFS (nasdaq: ABFI - news - people ) soften the blow when $309 million worth of the notes--with rates as high as 12%--mature over the next seven months. This would also allow ABFS to realign its balance sheet by reducing debt and increasing equity. Though the company says that note holders tend to reinvest, if they all cashed out, ABFS would have a hard time paying.
What's in it for the note holders? The conversion plan offers them a chance at preferred stock that pays ten cents per share and converts into common stock after a lockup period of two years. They also get senior debt--with a rate slightly above the original note--that is backed up by the company's assets, a security blanket they didn't have with the unsecured notes.
The advantage for ABFS? By converting the notes and locking up investors in the preferred, ABFS can put off this short-term problem for two years. But take notice of this dire, but strikingly honest, warning in one of the company's Securities and Exchange Commission filings: "You should only invest in these securities if you can afford to lose your entire investment."
The $241 million (sales) ABFS makes money by funding home loans, servicing them and/or selling them off in bundles in the secondary market. The business is risky. It requires the company to make a series of assumptions about the life of a mortgage, including interest, default and prepayment rates.
The industry is extremely competitive. Top players include Countrywide Financial (nyse: CFC - news - people ), H&R Block's (nyse: HRB - news - people ) Option One, New Century Financial (nasdaq: NCEN - news - people ) and Novastar Financial (nyse: NFI - news - people ). It's also riddled with bankruptcies (remember The Money Store?) and allegations of excessive fees and predatory lending practices. Of the top 25 sub-prime companies doing business in 1998, 17 vanished from that ranking four years later.
According to its SEC filings, ABFS has typically not been able to make enough cash from this business to cover its operating expenses. Indeed, over the last ten months ABFS has lost almost $60 million. And now the notes, which have traditionally helped the company bridge the gap between operating expenses and cash flow, are one of the company's biggest burdens. So far, the company has switched $74 million worth of notes to preferred and senior debt. (It has yet to default on a note payment.)
Shareholders have similar headaches to contend with. Now, several class-action lawyers are gearing up a suit against the company alleging that ABFS duped its shareholders by managing, among other things, the default rates in the company's mortgage pools. ABFS routinely buys back poorly performing mortgages. By doing this, ABFS keeps the pool's default rate above an agreed level. If it didn't, it would be cut off from payments from the pool. For its part, ABFS made full disclosure of this practice in its filings.
It took 15-year-old ABFS only ten months to get into this mess. In May, ABFS received a civil subpoena from the U.S. attorney in Philadelphia. ABFS negotiated forbearance agreements with some clients who fell behind on their payments. The U.S. attorney was concerned they didn't realize the new arrangements allowed ABFS to speed up the traditional foreclosure process. It eventually resolved the inquiry with an $80,000 donation to a HUD-approved housing counselor. But the increased scrutiny scared away its credit lenders and the buyers of its mortgage pools.
The perceived fragility of its business model intensified almost over night. It couldn't fund or sell large amounts of loans. Within a month, ABFS announced a $29 million deficit for fiscal 2003. It lost another $26 million the next quarter. "Last summer was a challenge," says Albert Mandia, the company's chief financial officer. "But we are moving forward." The stock has taken a hit on the bad news. Prior to the subpoena, ABFS traded at $14. Now the shares change hands at $4 a share. Shorts own one-third of the float.
Anthony Santilli, ABFS's chief executive, is trying to keep the company he founded in 1988 out of the sub-prime graveyard. Santilli, a former vice president with the Philadelphia Savings Fund Society, owns 40% of the firm along with his wife, Beverly 200391. Their stake has dropped in value to $5 million from $17 million before the subpoena.
During a frenetic last half of 2003, Santilli and his management team tried to get things back on track. Over the summer, ABFS originated $86 million worth of loans, down from $246 million during the same period in 2002. In the fall and winter, ABFS negotiated two credit lines--one with J.P. Morgan Chase (nyse: JPM - news - people ) and the other with a Philadelphia hedge fund--valued at as much as $450 million. They also managed to securitize a $174 million mortgage pool.
But the deals didn't have the most favorable terms. The hedge fund could receive as much as $40 million in fees over the life of the line, three times the company's market capitalization. ABFS can't use any of the money to cover its operating expenses. And the lines will fund between 97% and 75% of a mortgage, depending on the credit quality of the loan; ABFS has to come up with the remainder. (ABFS says most of its loans are at the higher end of that range.) Lending guidelines also state the company has to keep its unsecured note debt at certain levels.
That presents another reason for the conversion plan. As note holders convert, the company's note debt decreases and allows the company to raise more cash without violating the credit line covenants. That allows the company to sell some of the $295 million new notes it has filed with the SEC and is currently offering to the public at 11.2% rates.
All of this presents a gut check for investors like Mark Lynch, a major in the Army who lives outside St. Louis. Lynch, who has an M.B.A., dropped $2,000 into the notes for his daughters. He also contemplated investing $20,000 of his family's nest egg. But after reading the hundreds of pages outlining the conversion deal--and promptly becoming confused--Lynch balked.
Now, he is holding his breath and waiting for his $2,000 notes to mature. He thinks his daughters may learn a tough lesson about investing. "I thought [ABFS was] giving Joe Six-Pack like me a piece of the action," he says. |
