Eye for opportunity.

It has been nearly six years since I collaborated with Dan Helle at Chicago-based CIVC Partners, a private-equity firm, on an article that addressed the role of private-equity investors in the mortgage banking industry (see "Smart Capital," Mortgage Banking, October 2000). In this column, we discuss some of the trends in the current environment, concluding that once again private-equity investment is poised to play a major role in the mortgage industry.

The cyclical nature of the mortgage banking industry generates windows of opportunity for private-equity investors. When interest rates decline, there is generally an influx of new marketplace entrants, and existing origination platforms expand in anticipation of increased origination volumes. However, when interest rates subsequently rise, origination volumes usually decline, often creating excess capacity and depressed margins. Such periods are usually followed by increased merger-and-acquisition activity as larger firms look to consolidate their positions in the marketplace and weaker firms are forced out.

While these conditions pose a challenge for the mortgage industry, they create opportunities for private-equity firms to make well-timed investments that can lead to real value creation.

Because mortgage stocks tend to fluctuate in an inverse correlation to the interest-rate cycle, private-equity firms can create significant value by intervening during turbulent times when valuations are at their lowest, and exiting from their investments when origination volumes peak and investor confidence is restored.

Looking back at the era of the Resolution Trust Corporation (RTC), a number of private-equity investors made notable acquisitions near the peak of the interest-rate cycle in the late 1980s and early 1990s. During this time, the RTC was required to dispose of $400 billion worth of insolvent thrifts and their mortgage banking subsidiaries. This led to an oversupply of mortgage banking assets. However, banks--the most logical buyers of these assets--were faced with a shortage of capital at the time, and did not have the risk appetite to place further bets on the mortgage industry.

Private-equity firms, such as CIVC Partners and New York-based MacAndrews & Forbes Holdings Inc., took advantage during this period of the markedly depressed prices for mortgage banking assets. They acquired Irving, Texas-based Sunbelt National Mortgage and Monroe, Louisiana-based Troy & Nichols Inc., respectively.

After Sunbelt was purchased in November 1992, CIVC Partners worked with management to expand the company's origination platform. When origination volumes rebounded in 1993 as the Federal Reserve cut interest rates and the economy strengthened, banks once again became active suitors for mortgage banking assets. In January 1994, CIVC Partners sold Sunbelt to Memphis, Tennessee-based First Tennessee National Bank, realizing an internal rate of return in excess of 100 percent.

MacAndrews & Forbes saw similar success with its investment in Troy & Nichols as it grew the company's origination franchise and scaled its servicing platform by integrating it with Houston-based First Gibraltar Mortgage Corporation, another one of its portfolio companies. In June 1993, MacAndrews & Forbes sold the company to New York-based Chase Manhattan Bank, realizing a return in excess of 100 percent.

In both cases, the private-equity investors understood that their franchises would better withstand the next inevitable downturn in the hands of companies with scale. They justifiably sold their investments to commercial banks that were committed to building a significant presence in the mortgage industry.

In May 1996, Boston-based BankBoston Corporation and Jacksonville, Florida-based Barnett Banks Inc. joined forces with Boston-based Thomas H. Lee Partners LP and Chicago-based Madison Dearborn Partners LLC to create the seventh-largest residential servicer at the time. By doing so, the banks were able to benefit from the scale required to compete in a business that would subsequently be dominated by megaser-vicers. The joint venture, named HomeSide Lending Inc., was taken public in January 1997 at $15 per share. In October 1997, Victoria, Australia-based National Bank of Australia announced it would purchase the company for more than $27 per share, allowing the private-equity investors to realize nearly 200 percent returns on their initial investment in the company in 1996, according to American Banker.

In May 2000, an investor group led by GTCR Golder Rauner LLC purchased Atlanta-based Homebanc Mortgage Corporation from Memphis, Tennessee-based First Tennessee National Corporation for $57.5 million. Homebanc was the only division of First Tennessee's mortgage unit that did not align with the company's plans to consolidate all of its mortgage businesses under an umbrella brand.

After the acquisition, the company steadily grew its origination platform as interest rates reached historical lows in 2003. In July 2004, Homebanc adopted a real estate investment trust (REIT) status and simultaneously went public, raising nearly $289 million in a tough initial public offering (IPO) market.

Today, CIVC Partners and Thomas H. Lee Partners continue to invest in the mortgage industry. Their investments in Agoura Hills, California-based Ownit Mortgage Solutions and Brea, California-based ResMAE Mortgage Corporation, respectively, demonstrate their belief that the industry can still provide attractive returns.

As today's economy faces yet another cycle of rising interest rates and an inverted yield curve, parallels can be drawn to events witnessed during prior cycles. Plagued with over-capacity, profitability is now being eroded due to competition for market share. Additionally, the popularity of adjustable-rate mortgages (ARMs) and affordability products such as option ARMs have translated into an abnormally high level of repurchases due to a rise in early payment defaults.

For example, Irvine, California-based Option One Mortgage Corporation, a subsidiary of H & R Block Inc., Kansas City, Missouri, reported a 102-basis-point increase in the level of loss reserves relative to origination volume in the second quarter of 2006. The company recorded a $102 million provision for loan losses due to an increase in the estimated recourse liability for loan repurchases and premium recapture reserves relating to loans sold in the past year.

Fremont General Corporation, Santa Monica, California, a leading subprime originator, reported a 185 percent increase in loan repurchases during the first half of 2006 compared with the first half of 2005, while its total loan origination volume grew just 7 percent during the same period. These market conditions have made it increasingly difficult for mid-sized mortgage banking companies to survive as independent entities.

The universe of potential buyers for mortgage banking assets may not be as large as it was even six months ago--another reason why the sector is gaining appeal for private equity. Although banks and thrifts may pursue mortgage banking acquisitions opportunistically, most companies with an active industry presence are looking to "right-size" their mortgage operations rather than expand them. The prospect of deteriorating credit quality and concerns about integrating a non-bank-owned mortgage banking entity into the increasingly regulated banking environment may inhibit banks and thrifts from making large acquisitions.

Since interest rates started rising, mortgage REITs and independent mortgage banks have seen their net worth gradually erode and valuations decline. Shut out by the equity markets, these companies lack the capital to finance acquisitions.

After the recent wave of acquisitions made by investment banks, many of these firms are focused on integrating operations, thereby reducing Wall Street's appetite for mortgage banking companies. Additionally, the investment banks may be reluctant to buy very large companies that have the potential to alter the risk profile of their overall operations.

The modest investment appetite of existing strategic buyers leaves private-equity firms as the buyers of "last resort." The favorable pricing conditions created by the present imbalance between supply and demand for mortgage banking assets, along with the hurdles currently facing the industry, provide an opportunity for attractive returns. It is also possible that private-equity investors could again apply their expertise to revive troubled companies.

Indeed, history can certainly repeat itself. As we have seen in recent months, there have already been three notable transactions involving private-equity players:

* In late 2005, Atlanta-based Roark Capital Group made a majority stake investment in Indianapolis-based Ace Mortgage Funding LLC, a leading mortgage broker. According to Roark, it intends to build a mortgage banking platform to extract value from Ace's internal lead-generation capabilities.

* In March 2006, New York-based Fortress Investment Group LLC acquired Dallas-based Centex Home Equity Co. LLC from Centex Corporation, Dallas. Centex decided that its home-equity loan operations had grown beyond the scale where management could operate the platform effectively.

* Soon after, an investor group led by New York-based Cerberus Capital Management LP announced the acquisition of a 51 percent stake in Detroit-based General Motors Acceptance Corporation (GMAC) for approximately $7.4 billion. Saddled by the financial challenges of its parent company, General Motors, GMAC was struggling to compete effectively. The new investment gives GMAC access to more cost-effective funding while providing its parent company with improved liquidity and the ability to participate in GMAC's future profitability.

With an increasing number of companies considering strategic alternatives, anticipation is growing at the prospect that more private-equity firms will capitalize on the window of opportunity created by the challenging conditions surrounding the current state of the mortgage industry. History is indeed repeating itself.

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 column. All market data referenced in this column have been obtained from public filings unless stated otherwise.

(NOTE: The views expressed in this column are those of the authors and not those of Deloitte Financial Advisory Services LLP, Deloitte & Touche Corporate Finance LLC. or any member firm of Deloitte Touche Tohmatsu or their respective 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.)