CDOs Wet Wall Street's Subprime Appetite

Dow Jones Monday, November 27, 2006 10:24 AM

By Steven D. Jones

Wall Street thrives on risk taking, and so what better investment these days than an arbitrage built around sub prime mortgages.

That is the engine driving consolidation of lenders that make home loans to buyers with credit trouble. Sub prime lenders sprinted ahead during the housing boom, only to see prospects wane as interest rates rose. With losses mounting, consolidation is sweeping the industry, but it's Wall Street that is emerging as the consolidator, not the banking industry.

In the past three months, Morgan Stanley agreed to buy Saxon Capital Inc.

for $706 million. Merrill Lynch & Co. struck a $1.3 billion deal to buy National City Corp.'s First Franklin lending unit, and Bear Stearns Co.

is

buying the mortgage unit of ECC Capital Corp. for $26 million in cash.

"Clearly the broker dealers are leading the charge," says Matthew Howlett of Fox-Pitt Kelton, an investment bank that specializes in financial institutions world-wide.

The reason is that Wall Street firms have built large businesses creating asset-backed securities, or bundles of sub prime loans that they sell to investors. And more importantly, asset-backed securities are a key component in another even more profitable product Wall Street sells called collateralized debt obligations.

"They need to be able to source assets to feed the CDO underwriting machine, and what better way to feed the machine than create more sub prime assets,"

Howlett says. "They can kill two birds with one stone."

Most asset-backed securities are priced in relation to the London Interbank Offered Rate. High-quality debt issues are priced at Libor, or a few basis points above it. Low-quality debt is priced one hundred to two hundred basis points higher.

Creating an arbitrage between those rates of interest is what is driving Wall Street investment banks to buy sub prime lenders.

Here's how it works.

Investment banks create CDOs and sell them to investors at, for example, Libor plus 70 basis points. Then with the proceeds, the banks turn around and buy asset-backed securities that are paying Libor plus 150 basis points.

The difference is 80 basis points before expenses, which is a gain for CDO equity investors.

But in addition the banks borrow money to leverage every dollar invested in the CDO by five, 10, or even 20 times. At 20-to-1 leverage investors in the example above would earn a 16% return before expenses.

"It allows investors to take a position in credit risk different than we have seen before," says Howlett.

CDOs are a way to repackage and transfer credit risk. While it is possible to issue a CDO backed by high-quality bonds, the structure is more relevant for marginal assets such as subprime home loans where the arbitrage is larger, says Howlett.

Because CDOs are a type of derivative, they sidestep limits on investing in low-grade debt that many institutions face. That opens the CDO market to insurance companies and pensions among others. And because of their potential for double-digit returns, CDOs are a favorite among hedge funds.

Profitable Investments

And of course another reason Wall Street really likes this process is because it's very profitable. Firms can pinch off a few cents of every $100 invested in the process in fees.

"Wall Street makes anywhere from 30 to 60 basis points on this entire process of securitizing loans and collateralized obligations," says Howlett.

"It's a very lucrative business for this industry."

Howlett estimates there were about $300 billion of CDOs outstanding at the end of 2005. Bankers issued about $70 billion of the obligations that year.

This year, he estimates the industry is on pace to issue up to $120 billion in CDOs.

The banks lump their revenue from asset-backed securities and CDOs into larger business units, but some hints of their profitability are emerging.

"Mortgage and CDO net revenues increased significantly when compared to the prior year," Sam Molinaro, chief financial officer of Bear Stearns, told analysts during an earnings conference call in late September.

Revenue in its fixed-income business was $878 million in the last quarter, up 19% over the same period the prior year.

The story was similar at Lehman Brothers Holdings Inc. (LEH), which has snapped up eight mortgage firms in the U.S. and Europe in the past three years. Revenue in its fixed-income origination business was $348 million in the last quarter, up 4% over the prior year and up 20% sequentially.

CDOs

are also known as CLOs, or collateralized loan obligations.

"Stronger demand for CLO products globally has helped us optimize terms on pricing and leverage loans," Chris O'Meara, chief financial officer of Lehman Brothers, told analysts during a September earnings call.

Lehman recently said its appetite for subprime lenders remained keen, even though it didn't emerge as a bidder in the past three months. But there may be more buying opportunities soon.

H&R Block Inc. recently disclosed it might sell its Option One lending unit, which last year made about $40 billion in loans. It was ranked as the fifth largest subprime lender with 6.4% of the market, by Inside Mortgage Finance, an industry trade journal published in Bethesda, Md.

Closely held Ameriquest Mortgage was the largest subprime lender last year, according to the magazine, with a 12.7% share of the market. Others in the top five were New Century Financial Corp. with 8.4% of the market, Countrywide Financial Corp. with 7.1%, and Wells Fargo Home Mortgage Inc., a unit of Wells Fargo & Co., with 6.8%.

More lenders may come on the market, as subprime borrowers, many of whom pay adjustable interest rates, are unable to pay. Recently lenders have even experienced defaults within the first few months of origination, so-called early payment defaults. But industry watchers say that won't deter Wall Street, which views the industry's problems as a buying opportunity.

"We're starting to see bigger deals now with Option One coming up for sale,"

says Howlett of Fox-Pitt Kelton. "We think we will begin to see over the next 12 months even larger deals."