The B&C Survivors ... the Envelope, Please.(Column)

It's "correction time" in the subprime industry. Over the past six weeks the death knell has sounded for firms such as Harbourton, Ownit Mortgage Solutions and Sebring Capital - and those are just the ones we know of.

These mortgage bankers went under because of loan buybacks. Each company sold mortgages into the secondary market with "reps and warranties." That means should the loan go south, the secondary investor has the right to "put it back" to the primary funder. At that point the funder has few choices: buy it back outright or accept a lower price on that loan.

The lower price workout sounds easy - but it's not, especially if you're operating on razor-thin profit margins and your shop has little in the way of available cash.

Let's say "Vincent Mortgage" sells a $100 million pool to Merrill Lynch at say 101.5. (Par is 100). (I pick Vincent Mortgage because I had an uncle Vinny who, in the old days, got overextended with some, shall we say, non-licensed lenders.) Merrill then says, "Great, sounds good, Vinny." Then, 60 days into the life of these loans early payment defaults begin to pile up and Merrill says, "Hey Vinny please buy back the pool, all $100 million."

Vinny Mortgage then says, "I really can't and don't want to do that, Mr. High Powered Investment Banker." Merrill then says, "Remember I'm also your main source of warehouse money. Either buy them back or I'm closing you down. Of course there's another solution, Vinny. We can renegotiate that 101.5 purchase price to 98 and you give me some money." Now, depending on how much money Vinny has, it might do that. But like I said, these are tough times for subprime lenders.

Many firms - including the ones I mentioned earlier - are choosing to close their doors instead of pay the piper. The reason they can't pay the piper is simple: they don't have the money, at least not that kind of money.

I use Merrill as the foil in my example because it's a well-known warehouse funder and buyer of loans from non-depository subprime firms such as Ownit. In fact the scenario I ...