With the bankruptcy of United Companies Financial on March 1, the specialty finance community witnessed the largest failure to date in subprime mortgage banking.

After having access to enormous amounts of capital as recently as early 1998, subprime home equity lenders, once the darlings of Wall Street, have seen their sources of capital dry up and stock prices plunge.

Many believe that the golden age for subprime lending, which began in the early 1990s, has ended. While the recent crisis brought an end to some troubling trends, it remains to be seen whether the worst of the crisis is over and which segments are best positioned to come out on top.

The most obvious precipitator of the current crisis emerged in August and September 1998 with the devaluation of the ruble and the continuing Asian crisis. Markets worldwide witnessed dramatically increased risk premiums on all high-yield instruments, causing a dramatic increase in the spread on participations in subprime mortgage pools. Almost overnight, the market awoke to the fear that it had neither the information nor the expertise to value these subprime mortgage residuals.

It also faced growing skepticism regarding the issuers' performance and valuation assumptions and servicing capabilities.

Many subprime companies found the market closed to them. Banks, too, reevaluated their positions and started to rein in warehouse lines in addition to asking tough internal control questions. The effect was a liquidity crunch as the lenders found themselves unable to securitize existing inventory at attractive prices and could not originate without their warehouse lines.

By September 1998, the high fliers found that these two primary sources of cash to feed their hungry businesses were either completely shut off or seriously limited. Without interest-bearing portfolios that provide traditional lenders a stable base of cash flow, these operations lived hand-to-mouth and depended upon their bank lines for the cash necessary to feed their recently expanded networks.

This cash crunch was exacerbated by an often overlooked feature of securitization: It is frequently a cash-negative business that only shows a current profit by virtue of the present value of the residuals to be received years in the future.

For many companies, the only strategy to prevent immediate failure was to sell off existing and newly originated whole loans to larger, better- capitalized industry competitors. At least the sale of whole loans, unlike securitization, had been a cash positive business. Unfortunately, the profit margin on whole loan sales, which even in better times had been only 25% to 50% of that from securitized pools, had also largely evaporated.

Moreover, making the switch from an issuer of mortgage-backed securities to a seller of whole loans had other complicating factors, such as more demanding underwriting and documentation standards. As a result, we have seen and continue to see the departure of the poorest-capitalized subprime lenders, which signals the end of two recent trends that contributed to the crisis:

Inefficient origination platforms

Many of the high fliers attained scale by originating through a set of broker-dealers not directly affiliated with the subprime lender. This created extensive price competition and reduced control of the product, primarily through loans to suspect customers and through loan churning.

Dependence on earnings from securitization residuals

By securitizing pools of cash flows, many publicly owned high fliers were able to report phenomenal profits but were forced by capital market pressures to continually increase production to demonstrate ever-increasing earnings per share. This created a sense that each quarter, the lending net had to be thrown at a wider circle of borrowers.

Concurrently, industry consolidation has begun. Over the last year, many of the poorer-capitalized, monoline companies have teamed with more established financial institutions such as U.S. Bancorp, First Union, Conseco, and Greenwich Capital Advisors. These players, faced with fewer and less aggressive monoline companies, have prospered.

The question whether the worst of the downturn is over is more complex. Clearly, the effect of the liquidity crunch has been absorbed. Several of the monoline companies, including FirstPlus Financial Inc., United Companies Financial Corp., Wilshire Financial Services Group, Southern Pacific Funding Corp., MCA, and Cityscape Financial Corp. have opted for or been forced into bankruptcy to absorb the shock.

No doubt many of these companies will never emerge from bankruptcy as going concerns or, if they emerge, they will be a shadow of their previous market presence.

Other companies such as Aames Financial have shored up their capital base by bringing in new strategic partners and equity-holders. Still other companies continue to muddle through, attempting a balancing act of reducing costs, decreasing reliance on brokers, and mollifying their warehouse lenders.

For now, after losing its weakest participants, the industry has weathered the latest storm. A phenomenally resilient and strengthening national economy helped the subprime industry pull out of the liquidity crisis. And, the subprime mortgage industry as a whole has demonstrated a loss experience at acceptable levels, notwithstanding a dramatic and sustained revaluation of the residual interests retained by the loan originators.

Over the long term, these mortgage portfolios have not been tested in more difficult economic climates. The wave of B and C securitizations that hit the market since the beginning of the decade has largely benefited from increasing home prices, strong economic growth, and ever-loosening loan refinancing standards.

A downturn in the economy coupled with an increase in the jobless rate could push delinquencies, default rates, and loss severities beyond the limits of many investors' most aggressive stress tests. It remains to be seen what happens to this asset class when subprime mortgage delinquencies and defaults rise from their current historic lows. Some suggest losses could rise by as much as 400%.

This would once again threaten the financial viability of the holders of the residuals of these pools as the market again reprices these assets. Only this time, the larger players, including the commercial banks, will have consolidated their positions and the decline may be deeper and broader, for the problem would then implicate the underlying assets and not just the valuations of the residuals.

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