The home equity industry hit several potholes in 1998, as equity disappeared and firms cut costs and in some cases closed shop, but observers are cautiously optimistic about 1999.

Sandler O'Neill & Partners is predicting that subprime mortgage originations will grow about 10% in 1999, to $176 billion. The National Home Equity Mortgage Association, the industry's largest trade group, predicts $315 billion of originations next year, up from $292 billion in 1998.

Subprime and home equity borrowers continue to pay their loans more promptly than FHA and VA borrowers, according to the trade group. About 94% of home equity borrowers are current on their payments, compared with 92% of government guaranteed borrowers, the NHEMA said.

Last year many specialty lenders took massive writedowns to cover rising prepayments as competition increased and interest rates declined. The underlying cause was issuers' unfamiliarity with their new loan products, according to the Sandler O'Neill report, written by analyst Michael McMahon. Lenders made incorrect assumptions about the performance of these gimmicky loans, which were designed to increase origination volume, Mr. McMahon said.

Next year the issues will change, Mr. McMahon said. As for prepayments, "I think that war is behind us here," he said. "I don't hear companies talking about prepayments anymore."

The next issue to face these firms could be credit quality, he said, though he added that firms are exercising caution.

"The turmoil in the subprime market in the past couple months has been a wake-up call for survivors," Mr. McMahon said. Companies are tightening underwriting standards and raising rates, he said.

Premiums are being cut on loans sold to conduits, Mr. McMahon added.

Despite last year's troubles, the industry remains attractive for some lenders, according to a study released in December by David Olson Research, a Columbia, Md., firm that specializes in home equity lending.

"Although the home equity industry is relatively less profitable than it has been historically, it is still more profitable than other segments of the mortgage industry," the Olson study said.

This year has seen an influx of new, larger, better-capitalized entrants to the market that will establish standards in the once-inconsistent industry, observers say.

Some of those with capital have bought companies "on the cheap," Mr. McMahon said. This week, Capital Z Financial Fund II, a fund partially owned by Zurich Capital Partners Group, this week agreed to buy a controlling interest in Aames Financial Corp. of Los Angeles. Recently, Greenwich Capital Partners bought 95% of IMC Mortgage Corp.

In other deals, well respected home equity companies lined up strategic partners, or sold for high premiums-in October, U.S. Bancorp bought a stake in New Century Financial Corp., and in April First Union Corp. purchased Money Store.

The nation's largest mortgage lenders will become "fierce competitors" in the home equity industry, because of their focus on operating efficiencies, according to Olson. "Only the most efficient players will survive."

The "current period of duress" will create a stronger industry in the long run, the Olson study said. "As more sophisticated players take over the industry," accounting and expense standards will develop.

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