Mego Mortgage is the latest specialty lender to take a multimillion- dollar hit because customers are prepaying loans faster than expected.
The Atlanta-based high-loan-to-value lender said after the market's close on Monday that a charge as large as $16 million may be needed and that this would have a "significant impact" on fourth-quarter earnings.
Aames Financial Corp., Los Angeles, and Green Tree Financial Corp., St. Paul, recently took large writedowns for the same reason, prompting spooked investors to flee the subprime sector. When customers prepay loans, it wipes out profits that the lenders have booked in anticipation that the loans will be sold.
Prepayment speeds increased significantly in September and October, then slowed in November, Mego announced.
Mego told analysts it now expects 17% of the loans it makes to be prepaid before they are 18 months old. The company had previously estimated only 12% would prepay in that time. Mego's four securitized loan pools total $106.3 million and are all less than nine months old, which is early for loans to begin prepaying.
Mego was a victim of "correspondent churning," chief executive Jeff Moore said. Correspondent lenders are selling loans to Mego, then calling borrowers, refinancing them into new loans, and selling these credits to competitors, he said.
Shares of Mego stock tumbled on the news. By midday Tuesday, the share price had fallen to $3.84, from Monday's close of $4.75. By 1 p.m., trading volume was more than triple the daily average.
Analysts blame heavy competition among specialty finance companies for the industrywide increase in prepayment speeds, as well as the companies' reliance on direct mail marketing and brokers.
"Brokers are really the bane of this industry," said Len Blum of Prudential Securities. They will "refinance borrowers into whatever they can" in order to earn origination fees.
Some lenders have "premium recapture" arrangements with their brokers, which force the broker to refund part of a loan origination fee if it prepays early. But the recapture clauses are rarely enforced, Mr. Blum noted, because they ruin relationships between brokers and lenders.
Direct marketing fuels rising prepayment rates, Mr. Blum said, because lenders draw from target lists of their competitors' borrowers.
The issue is especially crucial to publicly traded home equity lenders. Most securitize loans and use gain-on-sale accounting to book earnings.
"Ultimately when you're judging gain on sale, you're making assumptions, and prepayment assumptions are the most important," said Hugh Miller, chief executive of Delta Funding Corp., Woodbury, N.Y. Delta has recently raised its prepayment assumptions on pools of adjustable-rate mortgages.
Prepayment penalties are the best way to keep refinancings in line, Mr. Miller said.
The industrywide alarm is understandable but may be overdone, said Reilly Tierney, analyst at Fox-Pitt, Kelton, New York. He said, "There's no question there's been a secular increase" in prepayments. But he added, "The question is, is it large enough to impair earnings, and is anyone good at preventing them?"
Lenders who have only retail origination channels are most likely to keep prepayments under control, Mr. Tierney said.
Prudential Securities analyst Jennifer Scutti said she keeps a close eye on prepayment speeds. "Keep in mind that one month doesn't make a trend," she said, adding that most of the companies she follows are in "pretty good shape."