Judging by the types of loans it is no longer originating, subprime lender Fremont Investment & Loan may have a house recipe sure to provide a healthy portion of early payment defaults: begin with a stated income 80/20 combo loan, mix in a purchase money home buyer with a FICO score below 640 and then bake in a low home price appreciation environment. Cooking times vary by geographic area.
While Fremont executives say they, for one, have changed their lending practices, they, and the secondary market, are now beginning to deal with the aftermath of what appears to be an industry-wide problem with 2006 subprime loans. Four home equity ABS securitizations backed by the Santa Monica, Calif.-based lender's loans have piled up on rating agency watch lists in recent weeks - two issued just this year and two from 2005.
Moody's Investors Service on Nov.10 put on watch for downgrade the two lowest rated tranches of SG Mortgage Securities Trust 2006-FRE1. Standard and Poor's followed suit shortly after, and in the early days of the following week, Moody's watch listed yet another tranche from a 2006 deal backed by Fremont collateral - MASTR Asset Backed Securities Trust 2006-FRE2 - followed by three tranches of Fremont backed deal Fremont Home Loan Trust 2005-1, and one tranche of the 2005-B series.
But while Fremont mortgages are so far performing worse than those of their peers, probably not by much, market participants say. "The 2006 vintage is on track to be the worst ever," an RMBS analyst said last week. Slowing home price appreciation and weakened underwriting standards are creating dramatically poor performance across a wide swath of 2006 mortgages. To many, the performance of 2006 deals backed by the mortgages hinges primarily on two things: the economy, and the ability for the borrowers to refinance.
According to sources close to the watch-listed deals, those caught in the wake of the rapidly defaulting collateral are revisiting reps and warranties and working with the companies in charge of servicing the troubled loans. Fremont itself - which was the third largest subprime wholesale loan producer for the six months ending in mid-September - said it has implemented a barrage of new policies since the defaults began to rack up, including new underwriting criteria, notable strides in fraud protection, oversight of those involved in originating the mortgages - from several new mortgage broker scoring initiatives to using licensed reviewers on a greater number of appraisals - and added scrutiny for so-called high risk loans.
Since Fremont implemented the changes, they've seen a 40% drop in first payment defaults, according to Ronald Nicolas, executive vice president and CFO of Fremont Investment & Loan, speaking during the company's third quarter earnings call. "That is why we are very optimistic and feel very bullish that we've gotten our arms and our heads around this issue," Nicolas said. First payment defaults on combo loans at Fremont reached a high of 5.8% in the second quarter.
But that is not to say the origination changes are easy. Like Fremont, a number of subprime lenders have made a bulk of their business on the types of loans that are now experiencing problems. Cutting out certain loan types altogether could quell the deluge of EPDs, but it could also dry up business that was actually working. "It is definitely not a one-to-one thing," said Warren Kornfeld, a managing director at Moody's. "To get a 2% decline in EPDs, they might have to reduce their originations 10%."
When Fremont began noticing what has been a threefold increase in EPDs this year, it analyzed its loans in order to determine which underwriting characteristics were the most troublesome. Taking a hard look at two trouble areas - purchase money and stated income transactions - the company's executives decided to eliminate the 80/20 stated income product offering to borrowers that had below a 640 FICO score, and to those below a 600 FICO with full documentation, Kyle Walker, president and chief executive of Freemont, speaking during the earnings call, said. "Within 60 days, I think most (lenders) followed our decision to make that change because those we found were a high percentage of our early payment defaults," he said. The lender also put greater restrictions on first-time homebuyers and increased the minimum loan amount for second liens.
Let's play hot potato
While Fremont-backed deals are the first of the 2006 vintage to be watch-listed for downgrade, the lender is not the only one facing a bout of early and first-payment defaults, and secondary market dynamics are changing as a result. At Fremont, buyback requests have increased to between 90% and 100% of delinquent loans from about 30% of delinquent loans last year. After a lender repurchases a loan, they can either hold onto it or try to get some money back through selling it as a so-called scratch and dent loan. In Fremont's case, depending on the quality of the loan, they could get anywhere from 50 to 85 cents on the dollar, they said.
As of the end of the third quarter, Fremont repurchased and repriced $345.7 million worth of loans, compared to $238.4 million in the second quarter. The company lost $9.6 million on the sale of whole loans and securitizations of $8.15 billion, compared with a gain of $8.4 million on the sale of $9.89 billion in the second quarter.
And at the same time buyers are modifying the types of securitizations they're willing to buy, in an effort to protect themselves from mounting costs associated with loan buybacks, lenders are also modifying the terms under which they sell the loans in order to avoid losing more money. According to one investor, the modified terms have some more established players holding back from purchasing HE ABS loan pools at all, leaving others to sweep up the deals. After all, he said, "how long can you sit on the sidelines when you've built this big mortgage machine?"
Fremont began asking for a 90-day limitation to request a buyback and a 45-day extension before determining there has been an EPD, in February. The changes were "initially met with a little bit of push back, but I think the other side was reasonable with understanding our point of view ... and of course, they want to buy loans, so I think that provided some motivation," a Fremont executive said.
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