Why Wilbur Ross Likes Subprime

The master of distress talks about the risks and rewards of scooping up ailing portfolios after his American Home deal

Wilbur Ross

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• digg this
• save to del.icio.us

It seemed an obvious match: distressed-company investor Wilbur Ross Jr. and the imploding subprime mortgage lenders. In what well could be the first of many moves, Ross' private equity firm, W.L. Ross & Co., agreed Aug. 6 to put $50 million into American Home Mortgage Investment during its bankruptcy reorganization. American Home, which stopped taking mortgage applications on Aug. 1 and fired most of its staff two days later, has been one of the first of this class of lender to hit bottom.

Ross's group will lend American Home up to $50 million in the form of debtor-in-possession financing, subject to court approval. The company can use the money to facilitate its Chapter 11 process, and Ross in return gets a seat at the bankruptcy negotiations. In past investments, he has often exchanged this debt for equity in the company as it emerges from bankruptcy, in turn becoming controlling owner of a smaller, but debt-free company.

For Ross it's a small step, but not, he expects, his last. Known for rolling up troubled steel, textile, and auto-parts companies, Ross expects it will be a year or more until things start to settle out in subprime. "We're not a hedge fund. We're long-term investors," he says. "We fully expect there will be a lot more trouble over the next year or so. You have to have a pretty big stomach for risk." Here are edited excerpts from an interview with BusinessWeek senior writer Nanette Byrnes:

Given how quickly things are going downhill in subprime, what could have made it attractive to you?

It's a valid business. What's wrong with it is the way they did it. Weak credit should pay a premium, not a discount. You had the strange situation that while a normal, credit-worthy borrower might pay 5.5 or 6%, a subprime borrower would pay 1% for a year or two and then the loan would be marked to market. It's silly to do that. And they often did without verifying the person's financial information or appraising the property. It's one of the more extreme examples of the fact that risk went by the board in the credit markets. Instead of risk-adjusted rate of return, these people were dealing with risk-ignored rate of return.

So what happens next?

We don't think those problems are over with at all. In the second half of 2007, $170 billion of adjustable rate mortgages will go from teaser rates to normal market rate. Next year $400 billion will go. We're into the storm, but the peak problem period is more likely to be sometime into next year. You have some individual months in 2008 when $40 billion will reset.

Now there's no liquidity in the subprime market. No one is making teaser loans. The rate shock is going to become quite severe, and people aren't going to be able to afford the payments. Typically, payments were more than 40% of borrower's income and generally will be going from 45% to 55% or 60% of their income, (so) it's just not going to be possible for people to pay that.

You'll just wait that out?

We want to be positioned long term with originating capacity and servicing capacity. We think those tools will come cheaply. We're prepared to have a rocky couple of years. There is need for [subprime lending]. Nowadays it's starting to get hard to get even a normal mortgage.

Are there some companies out there you wouldn't touch with a 10-foot pole?

Different places have different exposures. Some were mainly doing these undocumented loans. That's really scary because you're vulnerable to fraud and all kinds of morality issues. [The risk is] not evenly distributed. Some portfolios are in much worse shape than others. There are different credit scores, FICO, DTI. Some were more strict in how they applied those, some more lenient. It's not symmetrical. All the portfolios are having trouble. Some are just not salvageable. You can barely securitize right now. One of the huge challenges will be: How do you do originations when you don't have a place to sell the stuff?

Are the concerns beyond the subprime area?

The whole loan market is very, very weak right now. At the moment there is still tremendous liquidity in the overall financial market, but really none in subprime. There's a theory I have that there are two kinds of liquidity, one is physical and that continues to be strong. There's a lot of cash sloshing around. The more important is psychological liquidity, people's willingness to take risk, and that is drying up. There's a snap back away from the extremely permissive credit practices.

Then what's the argument again for getting into this business?

Subprime lending has been around for decades. It's nothing new. It's gotten exaggerated because of all these, what I would call, predatory practices. Going to uneducated people and conning them into believing they can get a home at 1%. What fueled that was the securitization. They were able to get the rating agencies to put strong marks on paper because of how they sliced and diced the loans.

But it's a business that has validity but at a much smaller size. Maybe it should be one-quarter the size it used to be. But that is still big. There are a lot of people whose income is growing, particularly younger people, and they'll move from [being] subprime to normal borrowers.

You've been talking about a coming rise in corporate delinquencies for a long time. Is that coming soon?

It will probably be around the end of this year or early next year. I've been saying defaults will be going up to about 3% in corporates. I still think that's a good estimate.