Servicing distressed home loans may well be a boom industry early in the next century.
Most servicers are scrambling to keep up with the extraordinary leap in plain-vanilla business spurred by the Fed's interest rate cuts last year-a bulge that is likely to bring another round of consolidation this year and next.
The beneficiaries will be giants such as Norwest, Countrywide, and Chase Manhattan, while the losers will be independent, midsize companies with no discernible niche. But the publicly held independents that specialize in distressed loans are likely not only to survive, but to thrive.
Many have tailored their platforms, staffing, and data analysis to the specialized servicing. Among these are Source One Mortgage Corp., Farmington Hills, Mich., Ocwen Financial Corp., West Palm Beach, Fla.; C- Bass, part of Litton Loan Servicing, Houston; and EMC, Irving, Tex.
"I call these specialists 'scratch and dent' companies," said Edward P. Elanjian, managing director of Cohane Rafferty Securities, Princeton Junction, N.J. "Their expertise is taking portfolios of troubled mortgages and fixing them up, often with the goal of securitizing them and selling them back into the marketplace.
"These companies got into the business often because they simply looked at their own portfolios and said, 'We've got mortgages that look like they're heading for default-What can we do to fix them up rather than write them off?'
"More recently, though, they've been saying, 'We've had such success here, maybe we should be looking at other portfolios we can buy that have high concentration of these loans," he says. "So there are a handful of these companies doing just that: buffing the scratches and pounding out the dents."
Mr. Elanjian and others expect more companies to jump into this business, not only because any downturn in the economy will increase demand for scratch-and-dent expertise, but because survival does not depend on being the lowest-cost producer.
"Companies such as ours have been specializing in servicing troubled loans since their inception, which in our case was the 1940s," said Jim Ozanne, chairman of Source One. The firm has a servicing and subservicing portfolio totaling $25 billion.
"We did what we did best but never thought there was a strategic opportunity to do more," he said. "What has changed in recent years is the servicing industry, which has become so competitive. It's harder and harder to make an acceptable return on equity. To do that, you need to find places where the big guys aren't playing, and this is one of them."
At Ocwen, the servicing portfolio last year totaled $8.2 billion. Jon E. Voigtman, senior vice president, loan acquisitions and servicing, says: "We don't measure success by how dramatically we reduce servicing costs. Rather, our benchmark is how successful we are in resolving nonperforming situations before a foreclosure.
"We're able to do this over 70% of the time; generally, the industry's success rate is in the mid-30s," he said. "Focusing on value associated with loss mitigation and the performance of an asset dwarfs the issue of servicing costs."
Those who buy these mortgages do so at a discount, with the expectation that they can be fixed and resold at a large profit.
"You can repurchase these securities from Ginnie Mae when they're delinquent 90 or 120 days," Mr. Elanjian said. "The FHA or VA will reimburse you on a delinquent loan that is, say, 150 basis points cheaper than the mortgage rate when originated.
"So you might get reimbursed 8.5% when the original mortgage was 10. To finance this transaction, you borrow short-term at 5% , so there's an arbitrage profit here.
"Then if you can fix it by replacing missing documentation or by bringing the customer current, you can sell it into the marketplace or refinance it a premium, so there's another profit stream," he said. "Then you might have a 10% loan in a 7.5% marketplace. So you can see why this is an extremely attractive opportunity for those with the necessary expertise."
Scratch-and-dent specialists hope to remain the servicer once the securities are sold.
"We're getting better at buying these and packaging them for resale, just as a lot of players are coming into the market and looking at this," said Melinda Cain, Source One's senior vice president of capital markets. "They feel there's money to be made, and this is crucial, as long as they have a partner who can service them effectively.
"Last year we put between four and six packages out there, totaling between $40 million and $90 million each," she said. "Now we're having discussions with three parties who want to buy these types of loans from others and have us service them because of our experience. They know we can get the job done."
As the number of distressed-servicing specialists grows, one can expect them to find niches.
"There's a spectrum of niches evolving," Mr. Ozanne said. "Some companies buy pools of mortgages where a minority are 90 days-plus delinquent, others where a majority are. We concentrate on those where there may be 10% to 12%delinquent, whereas others go for the pools where 75% are. "
The key to success is having the right platform, staffing, and experience.
"Most servicers develop their platforms with nonperformance as an afterthought, whereas ours was built for nonperformance alone - and then we moved into more general servicing capabilities," Ocwen's Mr. Voigtman said.
Mr. Ozanne credits his employees with much of Source One's success. "If you look at the tenure of our 40 managers, it's somewhere between 12 and 15 years," he said. "For all of our employees, it's close to 12."
Those who run into trouble in the future will probably be companies that don't know when to stay away from delinquent pools.
"You have to be able to look at a data base and predict how it's going to perform," Mr. Ozanne said. "In addition, though, you have to know when to look at something and walk away. We didn't buy many pools last year because so many people were coming into the business and bidding prices up.
"Success in this business is in the details," he said. "The devil definitely is in the details.