New Lease on Life for Lenders

The housing bust piques investors' interest in mortgage servicing.
Author:
Publish date:

Goldman Sachs

(GS) - Get Report

is the latest in a string of buyers interested in acquiring mortgage-servicing businesses.

The New York brokerage titan is reportedly in acquisition talks with Litton Loan Servicing, the Houston-based residential subprime mortgage servicer that is a subsidiary of Credit-Based Asset Servicing & Securitization, more commonly called C-Bass.

Litton specializes in servicing the most troubled loans, defined as "seriously delinquent mortgage loans." The firm has a loan portfolio of approximately $55 billion, according to its Web site.

Goldman's interest comes as more companies and private investors are eyeing what is perhaps a nugget of gold in the messy heap of the U.S. mortgage industry -- the servicing of mortgage loans.

Wilbur Ross, the 69-year-old billionaire turnaround investor, plans to acquire the mortgage-servicing business of now-bankrupt

American Home Mortgage

. Private equity behemoth Cerberus Capital is buying the servicing business of

H&R Block's

(HRB) - Get Report

struggling subprime lender Option One. It also owns a 51% stake on General Motors' financing business GMAC, which services both mortgages and auto loans. Dallas-based private equity firm Lone Star is buying servicing assets in its renegotiated purchase of

Accredited Home Lenders

(LEND) - Get Report

.

Part of the strategy in buying a servicing business is that firms are also purchasing distressed assets at steep discounts, observers say. Companies have the ability to profit if they can work out better loan terms for borrowers in trouble -- therefore avoiding foreclosure -- and eventually selling or securitizing the mortgages.

"No one wants origination capacity right now," says Matt Howlett, an analyst at Fox-Pitt Kelton. "What they do want is to buy some of the distressed loans in the market. There is a lot of potential upside in terms of the returns ... but in order to be able to realize those terms you need to control the servicing."

But targeting the servicing businesses is also like building the foundation of a house. The seemingly mundane tasks of bill collecting and loan monitoring are the steady cash flow engine of the mortgage business, and they take a more active role in creating profits during housing downturns. The more people struggle with their mortgages and interest rate resets, the less likely the borrower is to make prepayments. This means any loan is likely to stay alive longer, and lenders thus collect more servicing fees from it.

Congress has recently pressured mortgage servicers to provide more borrowers with loan modifications or other recuperative steps to avoid foreclosure, which is costly to both the borrower and the lender.

"In this environment where mortgage banks might not be making money on the origination side, servicing acts as an offset," says Howlett. "Clearly if you're not originating loans that would mean that a lot of borrowers aren't refinancing

or prepaying and that just means that servicing fees just get bigger and the servicing asset becomes more valuable."

So, when more borrowers were prepaying and refinancing their mortgages in 2002 and 2003, annual profits on origination peaked at about 90 basis points -- or close to $1,700 per loan, according to data compiled by the Mortgage Bankers Association and Stratmor Group. Meanwhile, the servicing side, which includes hedging and estimates of future prepayments, recorded losses.

By the first half of 2006, though, origination had fallen into the red as loan volume slid, while the servicing side was profitable -- with at least a $77 margin per loan.

Fred Cannon, an analyst at Keefe Bruyette & Woods, expects to see more consolidation in the industry. He notes that companies such as

Wells Fargo

(WFC) - Get Report

with "very strong capital positions are in very good positions to solidify their market share." At the end of June, Wells Fargo was the second largest mortgage servicer by volume behind Countrywide, according to

Mortgage Servicing News

.

Likewise,

Bank of America

(BAC) - Get Report

could capitalize on its relationship with

Countrywide

(CFC)

, which sparked when the bank took a stake in the company via a convertible security in August.

Goldman already owns one other small Texas servicing firm, Avelo Mortgage. In February, it also acquired subprime lender Senderra Funding of South Carolina, according to reports.

A spokesman for Goldman declined to comment on Litton.