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BAD LOANS MADE GOODSecuritization is a kind of alchemy. It transforms often risky loans into attractive packages for big investors. Here's howLousy credit record? Having trouble paying your bills? No problem! We've got just what you need. What's the magic bullet? The home-equity loan. Once it was a small sliver in the vast array of ways to lend money to needy consumers because very few people were willing to take the credit risk. Today, it is perhaps the biggest and most lucrative securitized loan product, dwarfing credit-card and auto debt. Indeed, many home-equity loans are taken out to pay off higher-interest credit-card debt. In 1997, $68 billion in home-equity loans was issued. That's quite a jump from five years ago when only $6.2 billion in home-equity loans were securitized. In recent weeks, the pervasive euphoria in the home-equity business has turned sour, as the riskiest securities have become almost impossible to sell. But the securitization business is still a lucrative money machine. The process is a kind of alchemy: It turns the riskiest individual loans to a household into a relatively safe investment product. People and firms who perform the alchemy have long-standing working relationships with one another. Here's how a typical deal works: Steve Whitford initiates the process. He is a branch manager at Old Kent Mortgage Co., a mortgage banker in Phoenix, Ariz. Old Kent, the 18th-largest mortgage banker in the country, generates more than $11 billion of mortgages--most of which is of the highest credit quality. It recently started targeting so-called subprime, or ''b and c,'' mortgage customers who have spotty credit records. The subprime market offers higher profit margins, and Whitford feels like he can help a broader range of people. To locate new customers, he combs through lists of homeowners with high-interest mortgages or gets local banks or collection agencies to send him their referrals. FINANCIAL HICCUPS. Before offering a subprime mortgage, Whitford delves into the customer's credit history. ''There are two different [issues],'' says Whitford: ''one-time events that happen like a divorce or loss of employment or medical problems that may cause a [financial] hiccup.... The other is the chronic b and c customer that since age 18 has always been slow to pay.'' Both types could qualify for a loan. When Whitford is satisfied, the mortgage is sent to Old Kent's Grand Rapids (Mich.) headquarters for final approval. Once a new mortgage is signed off on, it stays on Old Kent's books for at most 60 days before it is sold to an investor. Old Kent sells mortgages to a variety of financial institutions but often works with Ocwen Financial Services, which buys mortgages and performs securitizations. At Ocwen's West Palm Beach (Fla.) headquarters, Jeffrey W. Lucas supervises the deluge of mortgages acquired from roughly 1,000 independent regional brokers and bankers across the country. ''When we buy from Old Kent,'' says Lucas, ''they typically have held it for at least 24 hours. This way we can ensure they actually own the loan.'' Before purchasing it, however, Ocwen reviews the paperwork and makes sure the loan fits Ocwen's risk guidelines. If it passes muster, the loan is bought. The mortgage, like a piece of machinery on a conveyor belt, works its way toward Ocwen's securitization department, where Richard Delgado, vice-president of Ocwen's capital markets, takes over. Usually every three months, he packages between $100 million to $400 million worth of different mortgages for sale. Delgado's department, meanwhile, hammers out the details. Lawyers representing the various parties arrive by the boatloads. Accountants hired by the investment bankers pore over the loans yet again in what will take two weeks to two months before going public. During that time, analysts from rating agencies determine how well the loans will perform. ''At any given point in time, there can be 20 people on a conference call,'' says Delgado. BUMPIER MARKET. Nearly all deals entail what is known as ''credit enhancement'' to protect the investor from even the riskiest loans. The enhancement can consist of such items as insurance and excess collateralization. Then, a trust is created to buy the mortgages and issue what are called asset-backed securities, because the mortgages are collateralized by mortgage payments. The trust is also in charge of the cash flows, administered by an appointed trustee. Next is selling the securities. That is performed by an underwriter, usually an investment banking firm. Over the past few years Ocwen has worked with Lehman Brothers Inc. (LEH), one of the leading firms in the asset-backed securities business. Says Brad Andres, vice-president of Lehman's asset-backed finance group, ''There's a slightly different profile from one portfolio to the next, even from the same issuer because each can include a wide variety of loans from borrowers with different credit backgrounds.'' While the rating agencies and insurance companies are out to protect future investors or themselves, it is the investment banker's responsibility to make the deal as lucrative for the issuer as possible. That means getting the best price on bond insurance and the least costly credit enhancement. Lehman then slices the pool of mortgages into a dozen or more securities that are called tranches, representing different levels of risk and duration. Then Lehman traders hit the phones, calling potential buyers of the paper who get a feel for investors' appetite. Soon the securitization is priced and sold into the marketplace. One institutional investor who sometimes buys Lehman's asset-backed issues is Steven M. Tompson, managing director at Prudential Investments in Newark, N.J. One of the first areas he investigates is whether the finance company's collection division is up to snuff, since subprime borrowers tend to need lots of monitoring in paying their bills. ''The lower-rated, riskier tranches in deals like this used to be fairly easy to sell,'' says Tompson. ''But as the market has gotten bumpier and choppier through the summer, now it's pretty difficult to find investors.'' Tompson, in fact, has soured somewhat on the subprime world. ''Whether it is the home-equity or auto market, all of these guys have gone further down the credit spectrum, without getting paid any more for doing it. There's been so much competition. Companies refinancing each other, cannibalizing each other's clients...the liquidity crisis has exacerbated some of this.'' Yet Tompson adds: ''We are still buying. But we're careful in what were buying.''
By Debra Sparks in New York RELATED ITEMS
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Updated Oct. 15, 1998 by bwwebmaster
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