Subprime Mortgage Industry
Could Soon Face a Shakeout
By STEPHEN E. FRANK
Staff Reporter of THE WALL STREET JOURNAL
The "subprime" mortgage industry may be heading for a shakeout.
The companies, which make high-interest loans to borrowers with spotty credit records, have been a controversial topic among Wall Street analysts in recent months, with some analysts suggesting that aggressive accounting tactics and overly zealous loan growth were inflating the firms' earnings.
This week, one of the companies, Cityscape Financial Corp., based in Elmsford, N.Y., said its third-quarter earnings, which won't be released for another two weeks, would fall "materially below analysts' expectations." Cityscape said it hired Bear, Stearns & Co. to "explore strategic alternatives," and suggested it could run out of cash to meet its obligations in the "latter portion of the first quarter of 1998."
The company's stock, which has plummeted since the start of the year, fell further this week. After dropping 37% on Tuesday, the stock fell sharply again Wednesday, closing at $2.75, down 71.875 cents, in Nasdaq Stock Market trading. At its peak, Cityscape traded at nearly $35 a share. Standard & Poor's Ratings Group Wednesday said it lowered Cityscape's debt ratings and placed the company on CreditWatch pending further developments.
"Our concerns are about the liquidity of the company," said Standard & Poor's analyst Lisa J. Archinow.
Broader Concerns
Now, some analysts are suggesting other firms might suffer similar fates, and that still others could be hurt by the fallout. The industry's biggest names include companies such as the Money Store Inc., Aames Financial Corp. and FirstPlus Financial Group.
"We have concerns about the entire subprime home-equity group," said Tom Facciola, a Lehman Brothers Inc. analyst who has been one of the loudest voices warning investors away from subprime mortgage lenders. "There's been a feeling you need a recession for this to wash out. But this shows you don't need a recession," he said.
What's more, Mr. Facciola said, if he's right, even the stocks of the industry's best-managed companies will suffer.
So far, that hasn't happened. Wednesday on Nasdaq, FirstPlus Financial closed at $59.75, up 37.5 cents, while Money Store rose $2.8125, or 10%, to $30.625, on its announcement that third-quarter profit jumped 54%. But Aames, which put itself up for sale in August, plunged $1.50, or 10%, to $13, on top of a 7.6% decline the previous day, in New York Stock Exchange composite trading. On Tuesday, Duff & Phelps lowered Aames's credit rating, citing "the risks involved in implementing a new strategy, coupled with changing fundamental and competitive factors in the home-equity mortgage industry."
Accounting Issues
The controversy stems from the companies' practice of packaging the mortgages they make as securities, which they then sell to investors for the face value of the loans. Accounting rules require the companies to record any expected profits from the loans upfront, and pay taxes on them. But the way the securities work is that the mortgage lenders continue to service the loans, splitting the interest proceeds with their investors. Thus, the earnings, though they are recorded up-front, materialize only gradually.
Analysts cite several potential problems. First, many of the companies purchase their loans from mortgage brokers, paying the brokers a premium of 5% or more on the value of the loan. For example, a $100,000 loan may actually cost a subprime lender $105,000. But the lender only recovers the face value, $100,000, from the sale of the security, and must rely on future interest payments for the rest. While the hypothetical lender may record an up-front accounting profit from the loan, it is actually out of pocket $5,000.
A second concern is over the assumptions the lenders use in booking their profits, including how quickly the loan will be repaid, how many borrowers will fail to make their payments and the discount rate for calculating present value of future profits. Assuming a longer repayment schedule, or a low level of loan losses, can inflate paper profits, which will fail to materialize if the assumptions have been too aggressive. Aames, for example, took a $28 million charge in the second quarter after certain previous profit assumptions proved too optimistic.
Then, too, there is the issue of competition. Under gain-on-sale accounting, profits are directly tied to how many loans a lender issues, so a company must issue more and more loans to boost its earnings. That could lead some lenders to make unwise loans in search of immediate profits, analysts worry.
For their part, subprime mortgage lenders say it's unfair to lump together all the companies in the industry. "When there are company-specific issues that affect other companies, we think the market differentiates and views things within that perspective," said Money Store's chief financial officer, Michael Benoff. "You have different situations between some of the other companies and the Money Store. We're older, larger, more diversified and have a track record."
Officials of Aames, Cityscape and FirstPlus were either unavailable for comment or couldn't be reached Wednesday.
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