Shake-out predicted for B and C lenders

Real Estate Weekly, Feb 4, 1998

Rapid growth, industry shake-outs and continued consolidation will result in a stronger and tougher sub-prime lending market by the end of 1998. These were the major themes that shaped this year's predictions for the industry by Fairbank and Colony Mortgage. This is the fourth year that Fairbank Mortgage Executive Vice President Craig Cooper has issued his annual predictions for the non-conforming industry.

"This will be the year in which the challenges faced by the `Big Guys' will trickle down to the little guys," predicts Cooper, whose company does business throughout the Northeast, South and Midwest. "Changes over the next 12 months will result in success by the well-capitalized, more diversified organizations in the sub-prime industry, but they will be difficult on the smaller companies with shallow pockets."

Rationality Comes to Sub-Prime Lending

As credit tightens and the expectations of those buying loans raises, Cooper predicts some of the free-wheeling nature of the industry to disappear. "It won't be like the Wild West anymore," he says. "People won't be buying product for product sake like they did in past years. I expect a rationality to come to the market in 1998. Investors will become more picky when it comes to who they are buying product from. This will have a large impact on the smaller correspondents with limited net worth. Their balance sheets will be stressed because of their inability to buy back problem loans. I expect 1998 to be a difficult one for them."

Stricter Enforcement of Pre-Payment Penalties

To protect themselves from the impact of rapid pre-payments, major players will change their pricing models to reflect prepayment penalties, according to Cooper. "I expect 1998 to be the year in which the large companies modify the premiums they pay to correspondents and brokers to reflect their abilities to close loans that include prepayment penalties," he says.

Trend Away from Gain-on-Sale Accounting

"Look to 1998 as the year in which publicly-traded companies in our industry move to conventional accounting practices to report their earnings," says Cooper, whose background includes working as an institutional broker for Shearson Lehman Brothers in trading mortgage-backed securities. "You'll see many companies moving toward reporting cash earnings by the end of next year. This will be partially driven by the formation of REITs. By going to more conventional cash accounting, companies will reap the tax advantages of mortgage REITs as a way to raise capital."

Retail Emphasis to Shape Year

Look for a trend toward more retail originations, especially from the larger B and C lenders. "The large publicly-traded companies will probably beef up their retail originations by buying smaller retail companies," forecasts Cooper. "I also expect 1998 to be the year in which mid-sized companies become increasingly aggressive pursuing retail."

Domination By Major Players

"The sub-prime lending industry has always been fragmented with both large and small companies. That will change dramatically in 1998," says Cooper. "Things started to evolve two or three years ago, as large banks moved into the industry. In addition, agencies such as Fannie Mae and Freddie Mac are soon to join in. This theme will accelerate in 1998. Especially among the publicly traded companies, we expect to see a number of mergers and acquisitions and consolidations with large, non-industry players. This very well may lead to reduced margins."

High LTV Products to Gain in Popularity

Expect the product areas in 1998 to be shaped by high LTV products such as the 125 mortgage. Introduced this year, high LTV products will continue to be one of the faster growing segments for non-conforming lenders, according to Cooper. "There was a tremendous acceptance of these products by consumers and by the industry in general during 1997 and I expect that enthusiasm to last into 1998," he says.

Growth in the Alternative-A Market

"More and more sub-prime lenders are looking to move up the credit scale with alternative products such as 125s, jumbo mortgages, limited documentation and no-income verification loans," says Cooper. "That interest will expand in 1998."

Record Number of Refinances

With the outlook for lower interest rates continuing Cooper expects the highest rate of refis the industry has seen in five years. "With interest rates at a generational low, expect a rush to refinance, especially in the better credit area." he predicts.

Cooper forecasts that this high rate of "refis" will compound the industry's growing problem with pre-payments. "We will see record numbers of loan turnovers in 1998, which will have a significant impact on the profitability of industry," he forecasts. "This will shake the foundation of B & C lending."

A Chilled IPO Market

During next year, it will be an extremely difficult market for mid-sized B and C lenders that look to the IPO market for capital. "There will be a chill on Wall Street when it comes to investing in this industry in 1998," forecasts Cooper. "I expect many of them to use a different vehicle to raise capital such as REITs."