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Bad Blood Over Bad Loans


Everyone involved in the mortgage business got rich during the housing boom, including Wall Street. The biggest firms bought all the loans they could get their hands on, repackaged them, and sold them for a fee to hedge funds and other investors. Mortgage-backed securities issuance soared from $184.5 billion in 2000 to nearly $1 trillion in 2005, generating more than $1 billion in fees last year.

But now that the real estate tide is ebbing, trash is starting to wash up on shore. Mortgage delinquencies are zooming -- bad news for the banks, Wall Street firms, and investors holding loans.

In some cases, the original lenders are taking the biggest hits. In typical deals, banks agree to buy mortgages back from Wall Street in the case of a payment default within the first 90 days. Now some are writing big checks. H&R Block Inc. (HRB), owner of Option One Mortgage Corp. (HRB), reported a fiscal 2007 first-quarter loss of $219 million as it set aside cash for buybacks. Defaults forced NetBank Inc. (NTBR) and Fremont General Corp. (FMT) to buy back more loans as well. Fremont paid $238.4 million in the second quarter, up from $67.7 million a year earlier.

But Wall Street is feeling the sting, too. A few lenders have refused to buy back loans, prompting arbitrations and lawsuits. Bear, Stearns & Co.'s (BSC) mortgage affiliate, EMC Mortgage Corp. of Irving, Tex., is suing New York lender MortgageIT over $70.5 million in disputed buybacks. (Deutsche Bank (DB) said in July it would buy MortgageIT Holdings Inc. (MHL) for $429 million; it declined to comment.) And Lehman Brothers Inc. (LEH) is trying to recoup $20 million on toxic loans bought years ago from Beverly Hills Estates Funding Inc., whose principal, Charles Elliott Fitzgerald, is believed to have fled the country to a South Pacific island. "While the speculation is that he's offshore, we don't have any leads to his whereabouts," says Michael Wachtell, an attorney for the receiver overseeing Beverly Hills Estates Funding's liquidation.

SMALL-SHOP WIPEOUT

The losses could get much worse. Precise estimates are hard to come by, but D. Keith Johnson, chief operating officer of Clayton Holdings Inc. (CLAY), a loan-risk analysis outfit, says his firm alone has evaluated some $3 billion in potential buyback transactions this year. There's no telling how much of that will go sour. Smaller shops that feasted on shaky loans during the boom could be wiped out. "They popped up like mushrooms after a rainstorm," says Michael Robert Cavendish, an attorney at Boyd & Jenerette in Jacksonville, Fla., a firm that has won some arbitrations recently. "But many are undercapitalized." Analysts say buybacks were a major factor in the collapses of Acoustic Home Loans, an affiliate of California lender Metrocities Mortgage, and Texas-based QuoteMeARate.com. Metrocities declined to comment. QuoteMeARate.com's Web site and phone number are no longer in service.

Wall Street's latest strategy: Improve quality control by acquiring lenders. On Sept. 5, Merrill Lynch (MER) said it would pay National City (NCC) $1.3 billion for its First Franklin Financial Corp. unit. On Aug. 9, Morgan Stanley (MS) said it had agreed to buy Saxon Capital Inc. (SAX) in Glen Allen, Va., for $706 million. Analyst David A. Hendler of New York bond research shop CreditSights says New Century Financial, KKR Financial (KFN), American Home Mortgage (AHM), and a handful of other lenders could soon come on the block. Deals made now will leave buyers with plenty of time to clean house before the next real estate boom.

By Mara Der Hovanesian, with Dawn Kopecki in Washington


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