Was 1998 a great year in the mortgage business, or what?

Don't ask Robert W. Howard, the former chief executive of Southern Pacific Funding Corp., or Andrew A. Weiderhorn, who heads Wilshire Financial Services Group. Both companies went into bankruptcy over the last several months because of problems tied in large measure to the industry's record refinancing volume.

And don't ask Mike Perry of IndyMac Holdings (see article, page 8A) or H. Garrett Thornburg of Thornburg Mortgage Asset Trust. Their companies' shares tumbled in last year's second half, along with those of most other REITs, as earnings went into a tailspin.

The problem: while the heavy refinancings were driving originators' volume to a massive record, investor portfolios were being drained at an alarming rate.

The runoff, along with a number of external factors, snowballed into a severe liquidity crisis. Wall Street lenders were making calls for more collateral from the investors, which had a hard time raising cash because buyers of existing mortgages were scarce as values dropped even while the market was being flooded by new loans. The situation came to a head one day last October, when there were no big investors in the mortgage market until Freddie Mac and Fannie Mae stepped in to buy $9 billion of loans.

Oct. 8 was a day to remember for traders on Fannie's and Freddie's mortgage desks.

In the weeks leading up to Oct. 8, there was a "backdrop of tightening credit standards, especially on hedge funds, with their easy credit conditions going away," said Brian Brandenburg, vice president of mortgage portfolio management for Freddie Mac. This loss of liquidity, coupled with the crisis in Russia, created dramatic spread widenings that made the investment community nervous about mass liquidations, he said.

Wall Street was "involved in risk reduction as well, which made it difficult for them to make active, large-size markets," Mr. Brandenburg said. And lenders became concerned about the volatility as well.

These circumstances followed a period of "complacency" in the mortgage market during the first half of 1998, when mortgage spreads were "extremely tight," Mr. Brandenburg said.

Double-digit spread widening on mortgages relative to Treasuries occurred on several days in October and "surprised the market," he noted.

"A lot of the investors were leaving the markets in pursuit of liquidity," Mr. Brandenburg said.

Then as mortgage rates started to move back up, most people locked their rates on the same two days before Oct. 8, said Thomas Lawler, senior vice president for portfolio management at Fannie Mae.

"We had massive amounts of originations happening right at the same time as we had investors backing away from mortgages," Mr. Brandenburg said.

What followed was an "unprecedented selling by mortgage originators into the mortgage-backed securities market," Mr. Lawler said.

"We obviously can't see Wall Street from here, but the phones in our trading room, our market room were just nonstop," he said. "Every dealer, every trader on Wall Street said they were inundated. They couldn't keep pace with what was going on."

Requests to buy mortgages from Wall Street and even directly from originators flooded Fannie and Freddie.

Wall Street's "hedging with short positions in Treasuries did not work very well in the second half of last year," Mr. Lawler said. So Wall Street turned to the government-sponsored enterprises.

Fannie and Freddie bought a lot of the mortgages, keeping the market afloat, and they also were buyers in the debt markets.

By the end of the trading day on Oct. 8, Fannie Mae had bought $5 billion in whole loans and mortgage-backed securities - the most the company has ever bought in a single day, Mr. Lawler said. Freddie Mac declined to specify the amount of mortgages they purchased on this day, but said they were "major buyers," buoyed by a "long-term horizon." But industry reports put the Freddie purchases at about $4 billion.

"On this one day we actually purchased as much as we did for the entire month of November 1997," Mr. Lawler of Fannie said. Fannie's previous record was $2 billion in a single day, he added.

"I never left the market room," Mr. Lawler said. "That was one of the very few days I asked someone to get lunch for me."

What happened in the market in the second half of last year provides a cautionary tale about the volatile economics of mortgages.

The events are likely to have a long-term impact on the mortgage business. For one thing, REITs, seen as the next big investors in mortgages, have cut back their ambitions, at least temporarily. Some are restructuring their businesses. And mortgage investors are now much more likely to go to banks for funding than to Wall Street.

One disillusioned mortgage-investment executive said, "We didn't get any margin calls from banks, only from Wall Street. The banks are relationship- oriented and Wall Street is transaction-oriented. I'm going to think hard about borrowing from Wall Street again."

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