‘Sub-Prime’ Lenders Hurt in Credit Crunch

The days of easy money for many consumers with bad credit might be ending.

In a sign that an emerging global credit crunch might soon affect more American consumers, companies that specialize in so-called sub-prime lending to people with blotched credit records--often via high-interest home equity loans--are quickly running out of money as banks and investors cut off their funds.

The result is that many of the consumers who rely on such loans, frequently as a way to consolidate other debts, might be forced to pay even higher interest rates if they can get the money at all.

The sub-prime lenders’ woes are a rude awakening for companies that have enjoyed explosive growth--and profits--in recent years. The lenders thrived by pitching their products through mailers that resembled checks and through television ads that feature sports stars such as Miami Dolphins quarterback Dan Marino.

The companies’ fierce competition for borrowers fueled a surge in home equity loan originations, which are expected to total $55 billion this year, compared with $7 billion in 1990.

Now, however, the Wall Street funding that provided much of the capital for these loans is drying up, as recent severe losses in foreign financial markets and in the U.S. stock market have caused major banks and brokerages to shrink from risk-taking.

That has already forced some major sub-prime lenders into bankruptcy and decimated the stocks of most others.

“It’s reaching fairly cataclysmic proportions,” said Michael Sanchez, a portfolio manager at Hotchkis & Wiley, an investment management company in Los Angeles. “In the 11 years I’ve been in this business, I’ve never seen anything like it.”

The bottom line for consumers likely will be less competition, less loan availability and higher sub-prime rates, analysts said.

“There’s going to be a shakeout, and a lot of these lenders are going to disappear,” said Reilly Tierney, a special finance company analyst at Fox-Pitt, Kelton in New York.

The effects might be especially acute in California, home of many debt-burdened consumers--and the sub-prime lenders who target them.

More than 2% of Los Angeles County households declared bankruptcy last year, a rate almost double the national average. Richard Pittman, director of counseling for Consumer Credit Counseling Service of Los Angeles, estimates between 2% and 15% of consumers nationwide have bad credit. Many more are burdened with high credit card debts, he said.

Those consumers are the main audience for sub-prime lenders, who specialize in two types of loans: standard home equity loans to people with bad credit, and high loan-to-value lending, which often means extending home equity credit that, when combined with a first mortgage, exceeds a home’s value.

Sub-prime lenders make their money by charging higher rates and fees. While a traditional home equity loan to someone with good credit might carry a 9% rate, sub-prime lenders typically charge 11% to 14%, plus up to 10% of the loan amount in additional fees.

Lenders to people with questionable credit have experienced problems before, particularly in the early 1990s, when a recession led to more defaults and delinquencies.

What’s unusual about this particular squeeze is that it’s not the consumers’ fault. While delinquencies on sub-prime loans have increased as lenders reach out to people with poorer and poorer payment histories, the problem so far is with the firms themselves and their sudden inability to get funding.

Sub-prime lenders package most of their loans and sell them as securities to big investors: pension funds, insurance companies and banks who want the juiced-up yields on these higher-risk investments.

The firms rely on banks and brokerages to lend them money to tide them over between the times the loans are made and sold. Until recently, banks and brokers such as Merrill Lynch made tidy profits underwriting new issues of these so-called asset-backed securities.

But now sub-prime lenders are being hit from two directions. Many investors that once bought the securitized loans are backing away amid global financial turmoil, preferring super-safe U.S. Treasury securities instead. At the same time, banks and brokerages are cutting off many of the lenders’ lines of credit, fearful of being on the hook to a borrower that might develop financial problems.

“The market’s focus has gone from return on capital to return of capital,” said Charlotte Chamberlain, an analyst at Jefferies & Co.

A similar flight to quality has affected regular mortgage rates, which increased last week as investors demanded higher returns.

The sub-prime lenders’ problems could ease if institutional investors and major banks and brokerages come back to the market soon. But some lenders have already suffered irreparable harm.

Oregon-based Southern Pacific Funding Corp. fell into bankruptcy on Oct. 1. It was followed by Criimi Mae Inc., another major sub-prime lender, on Oct. 5, and by Cityscape Financial Corp. on Oct. 7.

Investors in other sub-prime lenders’ stocks have responded by dumping the shares in panic. Some of the stocks plunged as much as 70% in the last week alone.

The worst hit have been lenders who specialize in high loan-to-value home equity lending, which offers consumers financing equal to 125% or more of their home’s value. The stock of one of the best-known 125% lenders, Dallas-based FirstPlus Financial Group Inc., has plunged from $46 in July to $3.13 now.

FirstPlus, which uses pitchman Marino in its TV ads, has been seeking a buyer for the company since late August, without success.

Large Southland sub-prime lenders also have been slammed. Shares in Irvine-based mortgage lender First Alliance Corp., for example, have lost 83% of their value this year, and stock in Los Angeles-based home equity lender Aames Financial is down 87%.

Many lenders are struggling with regulatory woes as well. Regulators have charged several sub-prime lenders with misleading customers and charging excessive fees. First Alliance said Thursday that it is under investigation by federal regulators and seven states for its practices but said it believes it has complied with all laws.

Borrowers themselves are filing lawsuits. Sunnyvale resident Barbara O’Donnell, 60, thought she was borrowing $140,000 from First Alliance but wound up $161,080 in debt, thanks to a loan origination fee of $21,950, according to her suit against the company. First Alliance denies the allegation.

Some lenders have already responded to the market chaos by increasing the interest rates and fees charged to those with questionable credit.

Pasadena-based IndyMac Mortgage Holdings Inc. last week raised the rates it charges for sub-prime home loans to help cover its risks, said Chief Operating Officer Tad Lowrey. IndyMac’s stock has fallen from $27 to $13 on worries about its sub-prime business, but Lowrey said that business amounts to less than 10% of the company’s lending.

Despite all of the worries, however, analysts say sub-prime lending isn’t about to disappear. Instead, it is likely to shift to larger, better-financed companies that can provide their own funding.

Large, well-financed lenders such as Ford Motor Co. have sub-prime lending units, as do big banks such as Norwest Corp., which is buying Wells Fargo & Co. Tierney predicted other large lenders, including The Associates and Household International, will eventually step up their sub-prime lending as weaker players fail.

“The sub-prime market is not going to go away,” said Tierney. “It’s too profitable.”