Headlands Thrives in a Specialized Niche

Every time Peter T. Paul sees another bank merger, he says, he smiles a little bit more.

Bigger banks mean less competition, explains the chief executive of Headlands Mortgage Corp. The Larkspur, Calif.-based company specializes in "alternative A" mortgages, which don't quite fit Fannie Mae's and Freddie Mac's underwriting guidelines.

Small community banks and thrifts used to make these loans, he said. "The regional vice president would have underwriting authority, and the bank would hold the loan in its portfolio," Mr. Paul said.

But mergers and acquisitions have eliminated many small banks, leaving instead by-the-book institutiions that have standardized their underwriting to reduce costs, and thus turn down these borrowers. "It eliminates flexibility," he said.

Headlands serves as a prime example of the some of the fundamental dynamics of the mortgage business. While the industry is consolidating overall, small companies in specialized niche businesses are in many cases thriving.

The predominantly wholesale company's loan production this March was $654 million, a 148% increase over a year ago. In the first quarter of 1998, the company originated $1.5 billion in loans, against $3.7 billion for all of 1997.

Headlands' stock has performed well since its $96 million initial public offering in February despite a disappointing initial price. In October 1997, when Headlands filed to offer eight million shares, the estimated price was $14 to $16 a share, but it only got $12 when the offering was made in February. The stock has traded as high as $18 since then.

UBS Securities and B.T. Alex. Brown initiated coverage of the company with "strong buy" and "buy" recommendations, respectively, while NationsBanc Montgomery rated the stock "hold."

UBS Securities analysts say that their ratings reflected their confidence in Mr. Paul's leadership. "Peter Paul has reinvented himself a dozen times," said analyst Gareth Plank. "He's not a one-trick pony married to alternative-A lending."

Mr. Paul has more than 27 years of experience in the mortgage industry. Before founding Headlands in 1986, he worked in secondary market loan sales, as an executive vice president for a small mortgage company, and with a large thrift.

In 1998, the company, which is concentrated in the West, is reaching out to East Coast borrowers with sales offices in Florida and Washington.

Headlands borrowers are not "subprime," the company stresses. Credit scores average above 700, and loan-to-value ratios run about 75%, Mr. Paul said.

Despite the borrowers' often excellent credit history, they have other extenuating circumstances. For example, the borrower may have just changed jobs, Mr. Paul says. "The agencies require you to be in a job for two years," he says. "But what if you're only there six months? Like many agency rules, there's a reason to put up a caution sign, not a stop sign."

A little more than a fifth of Headlands borrowers are self-employed, Mr. Paul said. Agencies do make loans to self-employed borrowers, but it's "not their main focus, so they charge a premium for it," he said.

The company also does a sizable amount of jumbo loans and home equity lines of credit, as well as conventional mortgage loans.

Mr. Paul may see some competition soon. Both Fannie and Freddie have pledged to expand underwriting guidelines to catch the same 'alternative A' quality borrowers that Mr. Paul targets.

But UBS' Mr. Plank thinks Mr. Paul has little to worry about. "Fannie Mae doesn't do things quickly," he said. It could be two to five years before the government-sponsored entity rolls out a comprehensive program, and "in that time Headlands could have reinvented themselves many times."

Mr. Paul also emphasizes the company's flexibility. "We can manage hundreds of loan products," he said, and offer new programs "in a matter of weeks."

Not every program needs to be a success, he said, because of the number the company is offering.

Headlands is also beefing up its corespondent and retail business, said Steve Abreu, executive vice president.

Right now, banks looking to offset slim margins in traditional mortgage lending are eying niche companies like Headlands as smart acquisitions. But Mr. Paul says the company is not for sale - at least, not yet.

"We'd like to deliver a year or two" of solid growth and earnings before considering selling out, said Mr. Paul, who owns 42% of the company.

And Mr. Paul plans on achieving that growth by continuing to look at a different way of lending. If Headlands were a grocery store, he said "we'd rather be the sushi counter - though we'd continue to carry the white bread."

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