Bear Stearns agreed to buy Encore Credit Corp., the wholesale subprime lending business of ECC Capital Corp., last week, an event that added to a string of consolidations in the subprime lending industry.
Earlier this year, the subprime mortgage sector, which saw its fortunes rise with the booming residential market, began to falter as the housing market showed signs of weakness.
"You can argue that there was some overcapacity in the industry, so there would be some consolidation," said Chris Wolfe, an analyst at Fitch Ratings. Encore Credit, in particular, had a weak start when it went into business in 2002. The company seemed ill prepared to handle new Sarbanes-Oxley reporting requirements. Its parent company completed an initial public offering as a mortgage REIT in 2004, also at a bad time.
"Right out of the block, they kind of stumbled," said Vincent Arscott, an analyst at Fitch Ratings. "It appears they were not ready to launch the business. Enthusiasm for the mortgage REIT had started to wane."
Other troubles were brewing at Encore's parent company. January, ECC Capital Corp. restructured its operations, slashed compensation for senior management, skipped paying its first quarter dividend and announced a revision to its dividend policy. In an effort to improve liquidity and eliminate the required dividend distributions, the company also considered converting from a REIT to a C-Corp., although it has not done that yet.
Despite problems at the parent company, Encore Credit managed to originate $14 billion in subprime loans by the end of 2005, according to the company's annual report. Early on, Bear Stearns recognized Encore Credit's potential.
"Bear Stearns has been buying loans from ECC Capital for over three years and the performance of its loans has been favorable compared with other originators in the marketplace," said Jeff Verschleiser, a senior managing director in Bear's mortgage department. The ECC loans were eventually securitized through the Bear Stearns Asset Backed Securities shelf. "The acquisition of ECC Capital's origination unit will give Bear Stearns a substantial stake in the subprime lending business."
At $26 million, the acquisition price seemed low, according to Scott Valentin, an equity analyst at Friedman, Billings, Ramsey. The deal will give Bear Stearns access to Encore's loan origination infrastructure, but not the existing loan portfolio. Bear incurs all the costs of running the business, so the deal is essentially like buying a startup. Based on the $5 billion in loans that Bear Stearns expects Encore to originate each year, Valentin calculated that the price-to-originations metric was 52 basis points. That compares to First Franklin's 144 basis points and the 181 basis point differential when Morgan Stanley acquired Saxon Capital last August. "The deal pays for itself," said Valentin.
After the deal is finalized, Encore Credit will operate as a separate division of Bear Stearns Residential Mortgage Corp., the mortgage bank subsidiary of Bear Stearns.
"The Encore Credit sales force can now expect to have access to more competitive loan pricing, to have a broader product menu and to be integrated into Bear Sterns' state-of-the-art production platform technology," said Shabi Asghar, ECC Capital's president and CEO. Asghar will also become CEO of Encore Credit Corp., once the deal is finalized.
As part of the deal, Bear Stearns will take over operations of Encore Credit's operating centers in Irvine, Calif., Downers Grove, Ill. and Glen Allen, Va., and assume lease payments on the real estate.
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