The home equity industry acknowledged this year that in some cases, the Emperor really wasn't wearing any clothes. Companies with super-high growth rates fell apart, industry leaders took massive writedowns because of over- optimistic projections, capital dried up, and consolidation consumed some of the best-known names.
But many lenders insist that the worst is now behind them. The trials of the past 12 months have disposed of the weak and left behind stronger, more cautious survivors, they say.
"The good news is that people have been chastened," said Burke Dempsey, a managing director at Friedman, Billings, Ramsey.
Right now, the home equity industry is at its "inflection point during the shakeout," Mr. Dempsey said, where "people that know what they are doing can really make some money."
An increase in competition in the industry and an unusual kind of accounting were responsible for the majority of the problems. Lenders began poaching each other's customers-offering peers' customers lower rates or larger loans if they rolled their loans over.
Prepayment rates on home equity loans-usually much less interest-rate sensitive than first mortgages-skyrocketed.
Most home equity lenders securitize loans and rely on gain-on-sale accounting, which allows them to estimate and book expected profits before they are actually earned. Changes in prepayment speeds cut profits and several lenders took massive writedowns in the last quarter of 1997 and first quarter of 1998. This knocked down stock prices industrywide, and capital dried up.
Although the accounting method has given investors pause, neither it nor the securitizing of loans is apt to disappear from the industry, observers say.
The Securities and Exchange Commission even sent letters this spring to several accounting firms, inquiring about the practice, but the Financial Accounting Standards Board says it is unlikely to change the method.
And lenders and analysts say that even though securitizing the loans has led to problems, the process is integral to the industry.
Eschewing securitization of home equity loans because there have been problems would be "like saying let's go back to the horsedrawn carriage because people get into car wrecks," said Gareth Plank, an analyst in San Francisco with UBS Securities.
The growth of the capital markets has spawned an insatiable appetite for asset-backed securities, and securities backed by home equity loans have grown at a rapid pace, overtaking those backed by credit-card receivables as the largest in the field.
Overall subprime mortgage securitization volume was $18.31 billion in the first quarter of 1998, up 53% from a year earlier, according to Inside B&C Lending.
Green Tree Financial led securitizations in the quarter, with $2.15 billion in subprime securities, while IMC Mortgage Corp. and ContiMortgage tied for second place with $1.7 billion each.
Despite Wall Street's demand for these securities, several lenders decided that investors' skittishness after the most recent writedowns meant it was time to buddy up-and sold for eye-popping amounts. The Money Store Inc., Union, N.J., perhaps the best-known name in the business, will be bought by First Union Corp., Charlotte, N.C., for $2.1 billion.
Household made an $8.6 billion bid for Beneficial Corp. and insurer Conseco Inc. offered $6.5 billion for GreenTree Financial Corp. in March. More consolidation is definitely on the way, Mr. Plank said, though the "sense of urgency" has faded in recent months.
Big banks, which were looked to as the most likely acquirers after the Money Store deal, are no longer the frontrunners.
"If banks felt they had to buy, we would have heard about it by now," Mr. Plank said.
Rising competition also drove lenders to diversify into new types of home equity products and even whole new industries.
One of the hottest product to emerge, the high-loan-to-value mortgage, is drawing lenders of all sizes and risk preferences. The loan allows homeowners to borrow more than the value of their home, and use the excess cash for whatever they like.
Borrowers are increasingly using the loans to pay off high-rate credit card debt. The amount of outstanding card debt even decreased in the first quarter of 1998.
FirstPlus Financial Group, Dallas, the leader in the high-LTV market, increased annual net income 307% in 1997 to $139.2 million.
The fast growth of high-LTV products is drawing the attention of economists and legislators, who worry that consumers are piling on too much debt.
But the product continues to interest even banks and traditional lenders-by fourth quarter 1998, over $8.756 million in high LTV securities had been issued, $2.543 in that quarter alone.
Lenders like Contifinancial Corp. have been buying into the charged off credit card business to diversify their profit generating mix. Others have looked overseas-more than five different subprime shops now have United Kingdom offices, and companies like Associates First Capital Corp., Dallas, and Residential Funding Corp., Minneapolis, are looking into Asia and Mexico.
The push for new volume has its price, though-piling on too much volume without enough infrastructure proved to be the downfall of two companies in the sector.
Cityscape Financial Corp., Elmsford, N.Y. and Mego Mortgage Corp., Atlanta, are two companies that analysts say just grew "too far, too fast."
Cityscape, once one the favored stocks in the sector, fell to a combination of inadequate servicing, bad press, and regulatory woes in the United Kingdom. The company has since been delisted, and is selling off units to pay back creditors.
Mego Mortgage was forced to take a $16 million charge to cover rising prepayment costs. The company said in May that it may have to file for bankruptcy, though chief executive Jeffrey Moore says he is optimistic about turning the company around.
Nonetheless, cleaning up the mess is proving to be big business. Companies like Ocwen Financial Corp., West Palm Beach, Fla., and Wilshire Financial Services Group, Portland, Ore., are snapping up nonperforming portfolios of subprime loans for a fraction of their face value, and wringing out profits using specialized collection methods.
Ocwen has seen its stock price almost double since its IPO, to near $24. The company's net income increased 31% since the first quarter of 1997.
Most recently, Ocwen bought Cityscape's beleaguered U.K. division in May, for $4.77 million.
Despite the snags that many lenders have encountered in the past 12 months, the "home equity industry is still doing very well," said Mr. Plank, especially well-established companies with less-aggressive volume targets.
So what's the lesson to be learned?
"Maybe you shouldn't grow at 80% a year," says one investment banker. "Maybe there's a reason that banks rarely grow more than 15% a year."