Merrill Lynch's decision last week to acquire subprime lender First Franklin Financial Corp. swept yet another investment bank further into the loan origination business - a trend which some are coining as a "paradigm shift" within the maturing subprime mortgage market. The move is expected to provide Merrill - along with the other Wall Street banks that have preceded it - a cheaper and more direct path to reaping proceeds of securitization. Market participants said it might be too soon to predict, however, how that cost savings might alter pricing in the home equity ABS sector.
Merrill agreed to buy the San Jose, Calif.-based First Franklin from National City for $1.3 billion. The sale includes National City's loan processor National City Home Loan Services Inc. and online lender NationPoint. The bank is also expected to buy about $5.6 billion of First Franklin-originated loans from National City's portfolio. National City had been seeking a buyer for First Franklin for some time. Several investment banks, including Merrill, had been rumored as interested parties. (ASR, 07/24/06)
The acquisition is the fourth of its kind for Merrill. First Franklin originated more than $29 billion in loans in 2005, and was the 10th-largest subprime lender as of the second quarter. Home Loan Services, First Franklin's servicing platform, together with Merrill Lynch's existing Wilshire Credit Corp. servicing business, will create a total servicing portfolio of approximately $70 billion.
Vertical integration key
The market generally viewed the timing of Merrill's acquisition as a positive given the long-term strategy, although some felt the bank could have scooped up the lender at a lower price at a later date. In fact, a number of subprime lenders - including New Century Financial Corp. - are rumored to be on the block. When or if they will be acquired could be a matter of market sentiment. Merrill and Morgan Stanley are both being named as potential subprime lending business buyers.
Maintaining the entire spectrum of the subprime mortgage food chain under one roof is evolving as the best offensive measure for anyone in the game - from mortgage originators to investment banks, according to Jeffery Harte, an analyst with Sandler O'Neill & Partners in Chicago. "If you are in the mortgage business, even on the securitization end, you might as well have the economics of the entire chain," he said. For Merrill, the acquisition will create capacity for more market share in the home equity ABS market. "It has not been a particularly big product for them, whereas it has been for Lehman [Brothers] and Bear Stearns." Lehman and Bear are thought to have the most robust mortgage origination businesses on the Street. Morgan Stanley last month announced it would buy Saxon Capital for $706 million (ASR, 08/14/06).
Changing tides?
A number of mortgage lenders, perhaps most markedly Countrywide Financial Corp., have increasingly become big players in the lucrative securitization end of the business. Although now that Wall Street banks are buying up origination businesses, not all subprime lenders are happy about the new competition.
"The dynamics there, at least from my viewpoint speaking very frankly, is they don't know anything about the mortgage business - which makes them a very dangerous competitor," said Angelo Mozilo, chairman and chief executive of Countrywide, during the company's second quarter earnings conference call. "I think they'll be disruptive for a while." Mozilo said at the time banks were pricing loans "away from the market," and added that the companies have enough money to afford being ignorant to risk.
But not all lenders hold such an opinion. Michael Strauss, chief executive of American Home Mortgage said following the second quarter, "I don't think the entrance as being that inexperienced. I would tell you that I think that the large Wall Street firms that are in the market ... understand the price points pretty well. I don't think of them as competing excessively on price, I think of them as being able to use a lot of capital to create a strong franchise," he said. "So that is a concern to us, but we are used to it."
"We've always welcomed rational competitors, and we look at Wall Street firms as rational competitors," Scott Hartman, chief executive of Novastar Financial Corp., said about the trend during his company's second quarter earning call.
How involved will Wall Street firms be with shaping the subprime lenders they purchase? Some think not very.
"My sense is none of the investment banks are really going to change the market. They are not going to say, stop making IO loans or stop making 40-year amortization loans," said Sarbashis Ghosh, an ABS strategist at Merrill. And, as Harte of Sandler O'Neill pointed out - the banks are in the business of securitization, not loan origination for origination itself.
Theoretically, overall securitization volume in the sector should increase as investment banks are not likely to hold subprime loans on their portfolios. An overall decrease in origination volume, however, is likely to offset any gains in the near future, he said. Market sources said it was still too early to predict if investors would be willing to buy securities at a lower risk premium given the newer, deeper pocketed investment bank names set to back a wider array of subprime collateral.
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