First of two parts

Rumors of the death of subprime lending have been greatly exaggerated.

For much of the year mortgage industry professionals have been predicting that the number of subprime lenders would continue to contract and that companies specializing in so-called B- and C-quality loans would vanish altogether.

But industry consultants and other observers say many problems that plagued the subprime market during the past couple of years - for instance, falling interest rates that prompted an unexpected avalanche of prepayments and an investor boycott of subprime-asset-backed securities - have now disappeared or diminished.

Meanwhile the weakest competitors have shut their doors or been acquired, leaving stronger, more sophisticated players in their wake, observers say.

The independent shops have not disappeared altogether. Delta Funding Corp. of Woodbury, N.Y., is now being touted by the independents as an example of companies that have fought the good fight and demonstrated that demand persists for leaner, meaner, smaller competitors.

Lesser-known success stories include OptionOne Mortgage Corp. in Santa Ana, Calif., and Irwin Home Equity in San Ramon, Calif., according to industry consultants.

In short, subprime lending may be poised for a comeback - and independents may continue to rebound or be launched successfully - if the industry continues to get its act together.

But the ratings agencies that have been among the industry's biggest detractors in recent years are not issuing any ringing endorsements - for specific lenders or for the industry.

"The way I look at the industry, air is being let out of the balloon," said Mark H. Adelson, a managing director at Moody's Investors Service. "The industry got too blown up in the 1996-to-1998 period, but then there was the Asian financial crisis and the demise of gain-on-sale accounting, and that was when the air began being let out. You can't go back to those days."

Subprime lending "absolutely is not a 'one-size-fits-all' business," Mr. Adelson said. "The lenders come in all different stripes. Some are just a little bit subprime, and others are way subprime, and there are lot of opportunities to target different segments and markets, different credit grades and situations."

Another observer offered a tempered view.

Tom Abruzzo, a senior director at Fitch IBCA, said, "The future of the specialty finance players does not look bright," but that does not necessarily mean "that there may not be room for some of the smaller players within larger companies."

Some smaller lenders "now may have a good presence in a geographic area or a good servicing platform, for example, but those situations will be limited," he said.

The larger, more diversified companies involved in subprime lending say they see a bright future, with plenty of demand.

Both the independents and larger competitors said Citigroup's deal for the subprime lending giant Associates First Capital Corp. of Irving, Tex., indicates that the market is bouncing back.

Jeffrey Zeltzer, executive director of the National Home Equity Mortgage Association, a subprime trade group, said there is "no question that having a giant like Citigroup take this kind of action now is a positive for all of us."

Some major banking companies are bullish on subprime lending. Michael Youngblood, managing director of real estate research at Banc of America Securities LLC in Charlotte, N.C., said, "I don't know that we've had a corner to turn."

The market itself has not "undergone significant distress in 1999 or 2000," he said. "Business is good. In June we had $9.9 billion in new subprime loans industrywide and $8.2 billion in July, and we have not seen any significant deterioration in quality generally or in securitized pools."

The pattern of consolidation in the industry simply mirrors what is happening in the rest of the financial markets, Mr. Youngblood said. "Clearly there's a move away from independent companies to vertically integrated finance companies that can offer a full product line to consumers and fund loans either internally or by securitization on a purely voluntary basis."

Though the independents "have a role in terms of providing specialized credit, and they will continue to have one, the lesson of 1998 is that companies that are monolithically dependent on securitization have no future," he said.

Bill O'Neill, chief executive officer of OptionOne, said that keeping servicing in-house may be one key to success. "That's our competitive niche."

OptionOne, which was bought in 1997 by H&R Block Inc. of Kansas City, Mo., originates $5 billion to $6 billion of subprime loans a year.

"We sell the loans but keep the servicing because it affects how the loans perform over time," Mr. O'Neill said. "We get better results than our competitors because we concentrate on customer service but are firm with customers on the back end."

Yelling and screaming at borrowers "doesn't collect payments, and we understand that it's in our interest to keep customers in their homes because if we foreclose we lose 35% of the loan balance," he said. "It's all in how we execute."

Coming Wednesday: A look at Irwin Home Equity, a subprime lender that is using technology to improve loan performance.

Mr. Quinn is a freelance writer in Arlington, Va.

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