Conditions in the mortgage market have deteriorated to the point where investors who swooped in several months ago to take advantage of distressed situations have found things too distressed for their liking.

Late last week the Dallas private-equity firm Lone Star Funds said it was backing out of its $400 million deal to buy Accredited Home Lenders Holding Co., citing "drastic deterioration" of the San Diego subprime lender's financial condition.

In response, Accredited filed a lawsuit to enforce the merger contract, declaring that it "was specifically drafted" to prevent Lone Star from citing the turmoil in the mortgage industry and the capital markets as a reason for reneging on the deal.

Legal questions aside, analysts said that Accredited, which burned through nearly a third of its cash last month, would have a hard time fighting a drawn-out legal battle.

The suit also revealed previously undisclosed details of the bidding process that culminated in the deal with Lone Star. At least six investors submitted bids, and Lone Star raised its offer more than once to beat out another finalist, the suit says.

Neither company returned calls for comment.

In the complaint, filed Saturday in the Delaware Chancery Court for New Castle County, Accredited said that no specific event, no change in the capital markets, or even the company's financial deterioration could be considered a "material adverse effect" under its deal with Lone Star.

A "lengthy list of carve-outs from that definition" make it clear that any buyer "had to accept the risks inherent in the industry at this historical moment," the suit said.

Industry conditions "do not provide a basis for Lone Star to walk away from its obligations."

Last week MGIC Investment Corp. of Milwaukee said it could walk away from its deal to merge with Radian Group Inc. of Philadelphia, because of the impairments both are expected to take on their subprime joint venture, C-Bass LLC. Radian disagreed.

Scott Valentin, an analyst at Friedman, Billings, Ramsey Group Inc.'s FBR Capital Markets Corp., wrote in a research note issued last week that the agreement between Accredited and Lone Star "is well defined to the benefit of Accredited shareholders." He specifically cited the "material adverse change section" of the agreement. But Accredited does not have the financial position to engage in protracted litigation with Lone Star, Mr. Valentin wrote. Accredited's condition makes it "more amendable to a renegotiated price," particularly since its ability to continue operating "without an injection of liquidity would be highly questionable." (Accredited had $175 million of liquidity as of July 31.)

Investors seemed to lose confidence that the deal will close, at least at the current tender offer of $15.10 a share; at 4 p.m. Monday, Accredited's stock was off about 35%, at $5.82.

The shares had jumped 45% Friday, to $8.90, after the company eliminated two major obstacles to the Lone Star deal. In filings with the Securities and Exchange Commission, Accredited said that it won regulatory approval from states representing 95% of its loan production, and that it had an agreement to settle a shareholder class action.

In the suit against Lone Star, Accredited said that the buyer "failed to identify any particular condition to closing that Accredited would fail to satisfy."

The six bids it received in April ranged from $8 to $13 a share, according to the suit. A second round of bids whittled the field to Lone Star and one other bidder, which the suit did not identify.

Lone Star; its financial adviser, Piper Jaffray & Co.; and KPMG LLP, its accountant, conducted "significant on-site due diligence" and ran forecasts of Accredited's financial performance that used "assumptions provided by Lone Star," the suit said.

After two months of due diligence, Lone Star emerged as the winning bidder by raising its price by $1.85 a share, to $15.10.

In another SEC filing Friday, Accredited said it anticipates reporting a net loss of $40 million to $60 million for the second quarter, compared with net income of $41 million a year earlier, primarily as a result of "lower margins and adverse market conditions."

Accredited said that on June 30 it held for sale $1 billion of loans that had declined in value because of market conditions including the downgrades of mortgage-backed bonds by Moody's Investors Service Inc. and Standard & Poor's Corp. The amount of the decline "has not yet been determined" and is not reflected in its expected second-quarter loss.


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