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Banks try to return risky loans to originators

Posted on February 08 By MLP Blog

Efforts by major banks and Wall Street firms to unload bad U.S. housing loans are speeding up a shakeout in the subprime mortgage industry.

As more Americans fall behind on mortgage payments, Merrill Lynch & Co. (NYSE: MER), J.P. Morgan Chase & Co. (NYSE: JPM), HSBC Holdings PLC (NYSE: HBC) and others are trying to force mortgage originators to buy back the same high-risk, high-return loans that the big banks eagerly bought in 2005 and 2006.

Merrill demanded in December that ResMae Mortgage Corp. — which in 2006 sold it $3.5 billion in subprime mortgage loans, or loans to borrowers with poor credit records — buy back $308 million of loans whose borrowers had defaulted. In a filing this week for bankruptcy law protection, ResMae said those demands “crippled” its operations. The Brea, Calif., company said that repurchase requests were “severe and unexpected.”

As more subprime lenders face losses or bankruptcy, big banks also face another problem: Many lent money to small firms like ResMae so that those firms could make more mortgage loans to borrowers. It isn’t clear how much of these loans will be paid back to the banks. Wall Street firms also are increasing their own internal generation of subprime loans by acquiring smaller mortgage loan originators or processing companies.

In 2005 and 2006, banks such as HSBC and brokerage firms like Merrill Lynch went on a buying spree, snapping up subprime loans from typically small mortgage banks that had lent money to homebuyers. At the same time, many lenders were loosening their credit standards and making riskier loans.

HSBC kept many of the loans, while Wall Street firms chopped the loans into pools sold to investors as mortgage-backed securities.

In recent months, as home-price appreciation fell and borrowers faced rising interest rates, more people defaulted on their mortgages. That prompted Merrill Lynch and others to exercise their contractual right to demand the sellers buy back the loans. Under mortgage contracts, mortgage originators must often repurchase loans that default very early in their term or that come with underwriting mistakes, such as flawed property appraisals.

“Following early payment defaults, we exercised our contractual rights to return loans to ResMae and protect our financial interests,” a Merrill spokesman said. HSBC declined to comment. J.P. Morgan declined to comment.
Accredited Home Lenders Holding Co. (Nasdaq: LEND), a subprime mortgage lender based in San Diego, recently reported a loss of $37.8 million for the fourth quarter, partly due to heavy repurchases of dud loans from large loan buyers, compared with a year-earlier net income of $43.3 million.

Accredited uses credit lines from eight financial institutions to fund its mortgage lending. Those lines of credit contain covenants that could allow the lenders to demand prepayment of the outstanding balance if Accredited has two consecutive quarters of losses, the company said.

Accredited already has received waivers in some cases on those covenants and will need to seek more waivers from the lenders if the company remains in the red during the current quarter, it said.
Investment-banking firms and investment firms that bought mortgage-backed securities are hiring firms to scrutinize subprime portfolios for loans that violate contracts.

Clayton Holdings Inc. (Nasdaq: CLAY) is working with a half-dozen investment-banking firms to identify loans that should be repurchased. Clayton has also been hired by two hedge funds to review mortgage bonds they own for potential repurchases.

“Nobody was doing this in earnest before late last year,” says Kevin Kanouff, president of Clayton Fixed Income Services, adding that he expects the volume of putbacks “to trail off in the third or fourth quarter. The carnage that you are seeing … is not over.”

In a push to recoup losses, HSBC, which recently added $1.76 billion to its bad-debt costs for 2006 to cover ailing mortgages, has sued several small lenders in federal court in Illinois after they refused HSBC’s repurchase requests.

Credit Suisse analyst Rod Dubitsky said he expects repurchases to continue to rise for the next six months.

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