A huge year for M & A.

In January 2006, I wrote a column that discussed merger-and-acquisition (M & A) activity within the mortgage banking industry in 2005. As we begin 2007, it is time once again to step back and examine the wave of consolidation that took place in the mortgage banking industry in 2006, and discuss the outlook for the year ahead.

For M & A activity, 2006 was one of the busiest years the mortgage banking industry has witnessed in recent history--both in terms of number of deals and value. According to SNL Financial, Charlottesville, Virginia, there were 47 transactions announced through Dec. 1, 2006 (see Figure 1), compared with 31 deals announced in 2005.

The aggregate value of the 15 deals for which pricing was disclosed in 2006 totaled more than $36 billion.

Approximately two-thirds of the aggregate value was attributed to the acquisition of large thrift/megalender Oakland, California-based Golden West Financial Corporation by Charlotte, North Carolina-based Wachovia Corporation, while six acquisitions represented less than I percent of the aggregate value. The remaining eight transactions represented more than $12 billion, far exceeding the value of announced deals for which pricing was disclosed in 2005 and 2004.

The continued flattening and inversion of the yield curve, coupled with declining origination volume, helped hasten the pace of consolidation in the latter half of 2005. By the beginning of 2006, the impact of these factors became even more pronounced when combined with the wave of loan repurchase requests many mortgage companies began receiving from Wall Street firms that had purchased their loans. Numerous financial services companies with exposure to the residential mortgage industry began to consider strategic alternatives:

* Unable to operate profitably as a result of deteriorating operating conditions and abnormally high repurchases, many independent mortgage banks have seen their net worth erode in the past 18 months. Rather than risk violating their warehouse covenants or collapse into a position of insolvency, many independent mortgage banks such as Lake Forest, California-based Chapel Funding LLC and Carmel, Indiana-based Oak Street Mortgage LLC sought to merge with stronger counterparts in an effort to help strengthen their financial positions. While independent mortgage banks represented more than half of all sellers in 2006, they did not account for any major change in market share.

* Forced to pay out a large portion of their earnings to shareholders, and, in many cases, shut out by the equity markets, many mortgage real estate investment trusts (REITs) struggled to replenish their capital bases. Many were largely unsuccessful in tackling the depressed profit environment. The most severely affected companies were forced to reconsider the benefits of maintaining their REIT status. Last year saw five of the 26 publicly traded residential mortgage REITs--including Irvine, California-based ECC Capital Corporation; Glen Allen, Virginia-based Saxon Capital Inc.; New York-based MortgageIT Holdings Inc.; Los Angeles-based Aames Investment Corporation; and Jacksonville, Florida-based Sunset Financial Resources--seek merger partners, signaling that operating as publicly traded mortgage REITs may no longer be conducive to their growth strategies. Both MortgageIT and ECC had been hit with significant repurchase requests.

* Eager to limit their exposure to the anticipated decline in the housing markets, a large number of banks disposed of unprofitable mortgage divisions as they sought to take steps to "right-size" their operations. The most notable divestitures by banks included the subprime operations of Cleveland-based National City Corporation (First Franklin Financial Corporation, San Jose, California, and two affiliated business units) and Cleveland-based KeyCorp (Champion Mortgage Co., Parsippany, New Jersey). Atlanta-based NetBank Inc. decided to close down Meritage Mortgage Corporation rather than continue to sustain the losses that would be incurred during a sale process.

* Potentially recognizing that their mortgage operations had grown to a point where management no longer had the sophistication to maneuver through the challenging economic environment, several home builders divested their mortgage operations as management sought to focus on core businesses. Dallas-based Centex Corporation sold its growing home-equity loan business while retaining its conforming origination platform to help capture loans from customers in its home-building business.

* In one of the largest transactions of the year, debt-saddled car-maker General Motors Corporation, Detroit, sold a 51 percent stake in its mortgage banking subsidiary, Detroit-based General Motors Acceptance Corporation (GMAC) for approximately $7.4 billion.

* Although the divestitures of non-core operating subsidiaries accounted for only four transactions in the year, they represented some of the most prominent assets that changed hands during the year.

While tough economic conditions presented hurdles for many companies, they resulted in potential growth opportunities for many industry participants. The oversupply of mortgage banking assets has helped lead to tumbling valuations, and has helped fuel the acquisition appetite of a variety of investors:

* As a handful of mortgage REITs succumbed to the pressures of the economic environment and merged with other entities, a number of mortgage REITs sought to counterbalance the effect of declining spread income by attempting to reduce their cost of origination. They took steps to achieve this by expanding their origination capabilities and reducing their dependence on the secondary markets for origination volume through the acquisition of other mortgage lenders. For example, Melville, New York-based American Home Mortgage Investment Corporation and Vero Beach, Florida-based Opteum Inc. both made multiple acquisitions in 2006. Eager to increase the concentration of loans originated through its highly profitable retail channel, San Diego-based Accredited Home Lenders purchased Los Angeles-based Aames Investment Corporation in a transaction valued at approximately $344 million that vastly expanded its retail network.

* Banks, thrifts and independent mortgage companies collectively formed the most active group of acquirers, accounting for more than one-half of all the transactions announced in 2006. Some with a long-term commitment to the mortgage industry opportunistically pursued fill-in acquisitions designed to enhance their product offerings and expand their distribution capabilities in an effort to approve their cost structures through the addition of scale. Lake Oswego, Oregon-based Lime Financial's decision to take on the employees of Meritgage Mortgage Corporation was a prime example of this philosophy.

* With a long-standing history of affiliation with the mortgage banking industry, private-equity firms once again emerged as potential investors in 2006. Sensing an opportunity to potentially capitalize from the favorable pricing conditions created by the oversupply of mortgage banking assets and possibly revive troubled companies, private-equity investors sought to create value and realize attractive returns by acquiring scaleable origination platforms.

Examples include New York-based Fortress Investment Group's acquisition of Dallas-based Centex Home Equity Company in March 2006, followed by its acquisition of Champion Mortgage eight months later. In April 2006, as discussed earlier, an investor group led by New York-based Cerberus Capital Management acquired a 51 percent stake in GMAC, providing the company with a much-needed capital infusion that allowed it access to more cost-effective funding.

* In perhaps the most significant trend of the year, the industry saw numerous Wall Street firms enter the primary mortgage market. With origination volumes declining, many investment banks have found that funding their securitization platforms has become increasingly competitive. Seeking to vertically integrate their fixed-income businesses, five investment banks acquired mortgage origination platforms in 2006. These include: New York-based Merrill Lynch & Co. Inc., New York-based Morgan Stanley; Frankfurt, Germany-based Deutsche Bank; New York-based Bear Stearns & Co. Inc.; and New York-based Crusader Investments.

The mortgage originators acquired by these firms collectively accounted for slightly more than $105 billion of origination volume in 2005, representing not much more than 3 percent market share, according to data published by National Mortgage News. It is too early to judge whether the volume of acquisitions by the Wall Street firms will have a significant impact on the market share numbers of the megalenders. We will have to defer that discussion for a later Deal Talk column.

A common theme in many of the transactions was the "selectiveness" of buyers to purchase assets that were rid of potential repurchase liabilities. This often resulted in "partial deals" where loan portfolios and servicing assets did not always follow the buyer of the origination assets. For example, in the case of ECC, only the origination platform is set to be acquired by Bear Stearns, with the REIT surviving as a public entity to absorb current and future liabilities.

In the case of Columbus, Indiana-based Irwin Financial Corporation and Champion Mortgage Co., the servicing assets associated with the mortgage operations were not sold to the acquirers of the origination platforms, but were instead sold separately.

Similar to 2005, the megalenders were not active participants on the M & A front in 2006. Apart from London-based HSBC Holdings Plc's acquisition of Irvine, California-based Solstice Capital Group and San Francisco-based Wells Fargo & Co.'s acquisition of a 50.1 percent stake in Dublin, Ohio-based Centennial Home Mortgage LLC, megalenders continued to focus on right-sizing their operations and on organic growth in an effort to help make them more competitive through this cycle.

Calabasas, California-based Countrywide Financial Corporation, for example, in its ongoing drive to create efficiencies, intends to switch to a thrift charter. The only major consolidation among the megalenders was Wachovia Corporation's acquisition of Golden West Financial Corporation in a deal valued at more than $25 billion. The acquisition places Wachovia among the megalenders, and increases the company's previously underweighted exposure to the mortgage business.

In spite of the tremendous dislocation that occurred in 2006, the megalenders continue to control a significant portion of the primary market. During the first nine months of 2006, the top 10 lenders accounted for 63 percent of total origination volume and the top 20 lenders accounted for 78 percent of total origination volume, according to Inside Mortgage Finance.

Excluding the acquisition of Golden West Financial Corporation and the acquisition of GMAC--which was a partial divestiture to a private-equity firm--the largest market-share grabs were the acquisitions of 28th-ranked MortgageIT Holdings and 29th-ranked First Franklin Corporation, which collectively accounted for 1.8 percent market share during the first nine months of 2006.

As we go to press and look toward 2007, we see that a large number of companies appear to be "on the block," including Orange, California-based Ameriquest Mortgage Co. and Irvine, California-based Option One Mortgage Corporation, and we eagerly await the news of their potential disposition. Industry participants will likely continue to evaluate their alternatives in a currently shrinking mortgage market.

I believe there are still deals remaining to be done by Wall Street firms that will then focus on integration and execution of their strategies. Private-equity firms will likely be the opportunistic buyers, potentially setting the stage for a round of initial public offerings (IPOs) and sales the next time we are at the more enjoyable part of the cycle.

Brenda B. White is a managing director of Deloitte & Touche Corporate Finance LLC (D & TCF) and a principal at Deloitte Financial Advisory Services LLP, New York. She has been an investment banker to the mortgage banking industry since 1984. She can be reached at [e-mail]. Manish Pahlajani, a senior associate at Deloitte & Touche Corporate Finance LLC, contributed to this article. Deloitte & Touche Corporate Finance LLC (D & TCF) is an NASD and SEC registered national broker dealer. D & TCF is an indirect, wholly owned subsidiary of Deloitte Financial Advisory Services LLP. Investment banking products and services within the United States are offered exclusively through D & TCF.

NOTE: The views expressed in this column are those of the author and not those of Deloitte Financial Advisory Services LLP, Deloitte & Touche LLP or of any member firm of Deloitte Touche Tohmatsu or their affiliates. Any reference to or omission of any company in this column should not be construed as a recommendation to sell, buy or take any other action with respect to any security of any such company. Neither the authors of this article nor Deloitte & Touche Corporate Finance LLC is soliciting any action with respect to any security or company based on this review. The companies mentioned in this article may be clients of D & TCF or its affiliates or related entities. Unless otherwise stated, all market data and statistics referenced in this column have been provided by SNL Financial, Charlottesville, Virginia.

Figure 1 2006 Mortgage M & A Transactions (1)

                                       Sellers
Buyers              Bank Subsidiary  Megalender (2)  Mortgage Bank

Banks and Thrifts   2                1                9
Investment Banks    1                0                3
Investment Company  0                0                0
Megalender          0                0                1
Mortgage Bank       3                0                8
Mortgage REIT       1                0                4
Private Equity      1                0                0
Grand Total         8                1               25

                                    Sellers
Buyers              Mortgage REIT  Other Sub  Servicer  Grand Total

Banks and Thrifts   0              0          0         12
Investment Banks    3              0          1          8
Investment Company  0              0          1          1
Megalender          0              1          0          2
Mortgage Bank       1              1          0         13
Mortgage REIT       2              0          1          8
Private Equity      0              2          0          3
Grand Total         6              4          3         47

(1) Does not include deals involving the purchase of loan portfolios or
mortgage servicing rights
(2) Golden West Corporation, Wells Fargo & Co. and HSBC Holdings Plc are
classified as "Megalenders"
SOURCES: SNL FINANCIAL, DELOITTE & TOUCHE CORPORATE FINANCE LLC