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Big Investors Jumping Back Into Shaky Home Loans

By VIKAS BAJAJ and JULIE CRESWELL | Published: June 1, 2007


The subprime mortgage business is in tatters: loan volume is plummeting, defaults are rising and some of the biggest lenders have cut back or shut down.

So what is the smart money - private equity, hedge funds and investment banks - doing? They are swooping in and taking over those battered businesses, seeing opportunity amid the wreckage.

"There is a lot of money pent up," said Steve Probst, national sales manager with Fairway Independent Mortgage, a lender based in Sun Prairie, Wis. "And a lot of people are betting that the market will snap back quickly."

It is a risky proposition.

In many parts of the country, there is a glut of unsold homes. Defaults and foreclosures are rising, putting further pressure on home prices and mortgage lending. Some housing industry officials worry that the new infusion of capital may refuel aggressive and risky lending to people with poor credit, known as subprime borrowers, delaying a much needed winnowing of the business.

Those dark clouds do not faze the new money in subprime. Among those making the biggest bets is Cerberus Capital Management, which first made its name investing in distressed debt. One of the country's largest private equity firms, Cerberus has a record of making risky contrarian bets, including its recent agreement to take control of the troubled Chrysler Corporation for $7.4 billion.

Cerberus acquired control of the subprime lender Residential Capital last year, when it led an investment consortium that bought a 51 percent stake in G.M.A.C., the finance arm of General Motors. And in April, Cerberus, which also owns Aegis Mortgage, a subprime lender based in Houston, announced plans to acquire Option One, the troubled mortgage subsidiary of H&R Block.

Taken together, these acquisitions would make Cerberus the biggest subprime lender in the country, far ahead of large mortgage giants like Countrywide, Wells Fargo and others, according to first-quarter lending statistics from Inside Mortgage Finance.

It is unclear whether Cerberus will combine its mortgage operations into one company or operate them autonomously. Consolidating the businesses would offer streamlining and cost-cutting advantages, analysts say. Executives at Cerberus, which closely guards details about its strategy and investments, declined to be interviewed for this article and did not respond to written questions.

"They have certainly double-downed and have bought some extremely attractive operations - companies that have dominated their space," said Brenda B. White, a managing director with Deloitte & Touche Corporate Finance. "But now they're faced with executing on a plan, whatever that plan might be."

This year, when rising mortgage defaults and a credit squeeze on Wall Street have forced many subprime mortgage companies into bankruptcy, some analysts predict that the industry might shrink by a third or more. Many industry officials acknowledged that a shakeout was necessary to cull the industry of the lenders that led in making risky loans and forcing rivals to match them or lose business.

In the last several months, however, private equity firms and others have acquired, taken stakes in or provided fresh capital to companies that wrote nearly 20 percent of last year's $600 billion in subprime loans. It is, analysts and industry officials suggest, an unusually quick and substantial bet on a distressed business that by most indications is in the early phases of a long-term retrenchment.

With billions in capital available to them, investors like Cerberus, Ellington Capital and the Citadel Investment Group see an ideal buying opportunity. Yet trying to time the bottom of a sliding market has been tricky, even for smart-money investors like Cerberus. For instance, rising defaults and the cost of buying back poorly performing loans from investors left Residential Capital with more than $1.5 billion in losses in the six months that ended in March and the losses are expected to continue. (In March, General Motors, which still owns 49 percent of G.M.A.C., was forced to put an additional $1 billion into the unit because of the division's mortgage woes.)

Cerberus has insisted on a number of terms and conditions in its deal to buy Option One, suggesting that the firm has become more vigilant about not paying too much. As announced, Cerberus agreed to pay slightly less than $1 billion, but the final amount could range from as little as $400 million to $800 million, depending on how well Option One's business fares from now to the transaction's closing in October, according to estimates prepared by Kelly Flynn, an analyst with UBS.

That is a far cry from the $1.3 billion H&R Block executives said earlier this year that they expected to get for the unit. H&R Block could get more money from Cerberus if Option One turns a profit within 18 months after the deal closes. Barrett Burns, who has run lending businesses for Citibank and Ford Credit, says that Cerberus and the other investors in the mortgage business are being far more prudent in their purchases than big Wall Street firms like Merrill Lynch and Morgan Stanley were when they paid hundreds of millions of dollars for subprime companies last year.

"The investment banks that were buying last year were buying at the high," said Mr. Burns, who is now chief executive of Vantage Score, a company that provides credit scores that lenders use to evaluate borrowers. ”



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