Lenders hit by rising costs of servicing problem mortgages.

The slumping housing market and growing default rate among subprime mortgage holders has taken a big toll on Fremont General Corp. and other Los Angeles-area lenders.

Now those companies are bracing for an unpleasant side effect from bad loans they may not even have originated: the rising cost of servicing deteriorating mortgages.

Countrywide Financial Corp., IndyMac Bancorp Inc. and Fremont have servicing units that collect payments and distribute collections on loans they originated--and a good number of loans from other lenders. Indeed, Countrywide's servicing portfolio was a staggering $1.29 trillion in 2006, the second largest nationwide. Wells Fargo & Co. is No. 1.

Until the recent subprime implosion, loan servicing had been a relatively steady and dependable income stream as well as a hedge against down cycles in loan origination. The problem is, when home owners fall behind on their mortgages, the cost of servicing can rise dramatically.

A March 23 Bank of America Securities research report concluded that the average annual cost of servicing a mortgage is about $50 for performing loans but jumps to $1,000 for delinquent loans and $2,000 for foreclosures.

"As soon as a loan goes bad and borrowers start to miss payments, it becomes labor intensive and costly with large and small portfolios," said Tom Showalter, a vice president at First American Loan Performance, which makes software that loan servicers use to track loan performance. "You'd have to go back to 2000 to see any other loan vintage anywhere nearly as bad (as last year)."

Last month, amid the meltdown of the subprime sector, Fremont sold its subprime origination business and Countrywide and IndyMac drastically tightened their credit standards. Now the fear among analysts is that Fremont will have to exit the mortgage serving business--which had been a consistent performer--and rising servicing costs will hit IndyMac's and Countrywide's earnings.

Growing problem

While the companies don't break out the percentage of their servicing portfolios that are subprime, it's likely that with the record number of subprime loans generated over the past several years, the figure has grown. Combine that with the growing number of subprime mortgage defaults, and it's a recipe for bottom-line losses that are noticeable.

Countrywide was servicing $105 billion of its own loans in February, and borrowers were behind on at least one payment on 4.2 percent of those loans, according to a company regulatory filing. That's $4.4 billion in loans at risk for default. Countrywide has not released the delinquency rate for the entire portfolio, but if it's also around 4 percent that means the lender is looking at $50 billion of serviced loans at risk for default.

Bank of America Analyst Robert Lacoursiere said that in a worst case scenario, substantial hits to Countrywide Servicing portfolio could cause its earnings to fall by as much as 20 cents per share.

Meanwhile, IndyMac serviced some $147 billion in loans last year, up from $90 billion in 2005, and Fremont, which delayed its fourth quarter and fiscal year earnings reports, retained servicing fights on $1.8 billion of its own subprime loans. It also serviced an additional $8.3 billion on an interim basis in 2005, according to regulatory filings.

Countrywide and Fremont declined to comment on the matter, while IndyMac issued a statement last month that it does not expect its servicing portfolio to be largely affected by defaults, even though it services many socalled Alt-A loans, which are above subprime but below prime in credit risk.

Some analysts believe that Fremont may exit the servicing business altogether. If so, there well could be buyers. Just last week bankrupt New Century Financial Corp. sold its servicing business to hedge fund Carrington Capital Management LLC for $139 million.

Last month Fitch Ratings downgraded Fremont Investment & Loan's servicing portfolio, putting it on "watch negative," and giving it a "4" rating, only one point above the lowest possible rating of 5. (The credit and bond rating agency also issued a similar ratings pronouncement against Ameriquest Mortgage Co., Accredited Home Lenders Inc., and New Century (prior to its bankruptcy.)

Fitch said Fremont's downgrade reflected a concern that the Santa Monica-based lender will continue to face difficulty in funding its ongoing servicing operations, maintaining its servicing quality and attracting third-party servicing opportunities--especially after exiting the origination business following a cease and desist order last month from the Federal Deposit Insurance Corp.

Mary Kelsch, Fitch's senior director in charge of servicer ratings, said the agency lowered Fremont's serving portfolio for a number of reasons.

"With Fremont it was several factors but the main ones were the cease and desist order by the FDIC and the fact that if you stop making loans, you're left servicing bad loans and can't issue new performing loans to improve your portfolio," she said.

Theodore Kovaleff, an analyst covering Fremont for Sky Capital LLC, said he doesn't think Fremont will stay in the servicing business and that it may sell it or divest as it did with its subprime loan unit.

"These heightened servicing costs could in theory be offset with a late fee that servicers collect, but the servicer has to actually collect and that's where Fremont could run into trouble," Kovaleff said. "If you're a servicer, you're going to do your damndest to collect. And it's going to take time and, therefore, money--those are in short supply."

De-Fault Line

A bad mortgage loan is an expensive prospect for servicers. Here is the typical procedure followed:

* Day 1-29: Mortgage is late.

Past due notices are sent out.

* Day 30-90: Mortgage payment is delinquent.

Servicer steps up mailings and begins to make late-payments to mortgage backed-securities investors to cover the loss.

* Day 90-200: Foreclosure.

Servicer issues notice of foreclosure and must pay as much as 5 percent of legal fees, and starts to make bookkeeping adjustments reflecting the increased chances fees will not be collected.

* Day 200-400: Resale.

Now that foreclosure proceedings are over, the servicer takes possession of the house and incurs maintenance, insurance and tax costs as interim owner.

* Liquidation.

Now that the servicer has sold the property and incurs final transaction costs, the servicer is first in line to collect proceeds and be reimbursed for all costs except interest on principal payments, additional labor and correspondence.

Source: Business Journal research

BY JABULANI LEFFALL

Staff Reporter