Midyear M & A review.

The blistering pace of merger-and-acquisition (M & A) activity in 2006 has been carried through the first half of 2007. According to Charlottesville, Virginia-based SNL Financial, there were 22 transactions announced through June 4, 2007, compared with 25 transactions during the same period in 2006 and 49 transactions during all of 2006 (see Figure 1 for a list of the significant transactions in 2007 that have been announced as of June 4, 2007).

In terms of market share, the number of firms changing hands so far this year represented 6 percent of total residential mortgage originations in 2006 (representing companies for which originations were known). In fact, the exodus from the mortgage industry has become so pronounced that eight of the top 40 mortgage lenders have changed hands since the beginning of 2006, according to Inside Mortgage Finance.

Continued high levels of repurchase requests, declining home prices, an inverted yield curve and increased regulation have continued to create challenges for mortgage lenders in 2007. These conditions have taken a toll on subprime lenders in particular, and resulted in numerous bankruptcies or outright closures in the past six to eight months.

Eight of the 40 largest subprime lenders have sold their operations since January, Inside Mortgage Finance reports. More than 50 subprime lenders have been forced to either shut down operations or file for bankruptcy after failing to find buyers for their assets since December 2006. Collectively, these departures accounted for an additional 2 percent of the total residential mortgage market (representing companies for which originations were known).

Probably the most surprising bankruptcy was that of Irvine, California-based New Century Financial Corporation, one of the largest subprime lenders, filed in April 2007. The company sold its servicing platform to Greenwich, Connecticut-based Carrington Capital Management LLC in May 2007, but according to public reports the company received no bids for its origination platform and ended up shutting it down.

The 2005 and 2006 vintages of sub-prime loans are performing worse than any other vintage, and are defaulting at a higher rate than any other vintage. With the impact still unknown from the large number of 2/28 subprime adjustable-rate mortgages (ARMs) pending reset in the next six to 18 months, many potential buyers believe that the worst is yet to come. Moreover, the decline in subprime origination volume as a result of increased regulation and tighter underwriting standards has created significant excess capacity in the industry.

As a result of these conditions, mortgage companies--subprime companies in particular--have become difficult to sell. Fearful of taking on future liabilities that cannot be estimated with a high degree of certainty, buyers have tried to use more creative structures to acquire the portions of a company they find attractive, and leave the undesirable portions--including current and future liabilities--behind.

Buyers are aggressively negotiating pricing-adjustment mechanisms to be calculated at closing. In cases where a corporate parent is selling, buyers are also demanding and getting representations and warranties to protect them after closing, as a way to have more clarity as to the value of what they are buying.

In many cases, companies that have tried to sell have not been successful in constructing a structure for a transaction that would adequately protect a buyer, and have been unable to persuade potential buyers to take on the uncertainties that exist in today's market. As a result, these companies have had no alternative but to cease doing business and file for bankruptcy.

The trend of mortgage real estate investment trusts (REITs) exiting the business continued in 2007 with the sale of Columbia, Maryland-based Fieldstone Investment Corporation; the sale of the retail origination capability of New York-based New York Mortgage Trust Inc.; the sale of the retail origination capability of Vero Beach, Florida-based Opteum Inc.; and the bankruptcy of New Century Financial Corporation. In May, Kansas City, Missouri-based Novastar Financial Inc. announced it would abandon its REIT status, leaving only four publicly traded residential mortgage REITs that currently engage in lending activities with a total market capitalization of roughly $5 billion.

Just one year ago, there were 14 publicly traded mortgage REITs that actively engaged in lending activities with a total market capitalization of $10.3 billion. Counter to this trend, another REIT, Irvine, California-based Impac Mortgage Holdings Inc., announced the acquisition of Orlando, Florida-based Pinnacle Financial Corporation.

Unlike in 2006, when the megalenders sat on the sidelines and watched investment banks and private-equity firms engage in the flurry of M & A activity, the megalenders have been responsible for some of the most prominent deals this year: New York-based Citigroup Inc. strengthened its mortgage business through the acquisition of Ann Arbor, Michigan-based ABN AMRO Mortgage Group and the option to purchase the wholesale mortgage lending and servicing operations of Orange, California-based ACC Capital Holdings.

According to Inside Mortgage Finance, the acquisitions collectively account for more than $50 billion in mortgage originations, more than $300 billion in servicing volume and, if the acquisition of ACC Capital Holding takes place, would make Citigroup the largest servicer of subprime loans.

As part of its goal to penetrate the retail origination channel, Pasadena, California-based Indymac Bancorp Inc. acquired the retail operations of New York Mortgage Trust, mentioned earlier. Taking advantage of the trials and tribulations of their competitors, the overall top-10 lenders (including prime and sub-prime) continued to increase their overall market share and accounted for 69 percent of total residential mortgage originations in the first quarter of 2007, compared with 65 percent in 2006, according to Inside Mortgage Finance.

Private-equity firms have become opportunistic players in the sector, and are seeking to capitalize on the window of opportunity created by the current downturn in the cycle (see the Deal Talk column in the November 2006 issue of Mortgage Banking for a fuller discussion of this trend). The eighth-largest subprime lender, according to Inside Mortgage Finance--Kansas City, Missouri-based H & R Block Inc.--faced challenges in selling its subsidiary, Irvine, California-based Option One Mortgage Corporation, to New York-based Cerberus Capital Management LP, a private-equity firm.

The company was forced to run an extended marketing process after it received few bids for Option One, and finally settled for a purchase price well short of book value (price does not include $300 million potential earnout based on the financial performance of Option One Mortgage during the 12 months following the date of the acquisition).

Cerberus added Option One to its 51 percent ownership of Detroit-based GMAC LLC and its position in Houston-based Aegis Mortgage Corporation. In March, the 17th-largest mortgage lender, Mount Laurel, New Jersey-based PHH Mortgage, announced that it would be taken over by New York-based Blackstone Group LP, a private-equity firm.

In search of bargains, Chicago-based Citadel Investment Corporation and Carrington Capital Management also acquired sizable platforms out of bankruptcy. In early June, San Diego-based Accredited Home Lenders Holding Co. agreed to be acquired by Dallas-based Lone Star Funds. Interest in the mortgage business from private-equity firms and hedge funds is likely to continue, and the oversupply of assets is likely to result in bargains.

The tremendous dislocation witnessed over the past 18 months is testament to the cyclical nature of the mortgage banking industry. The capitulation of some of the biggest players is evidence that even those thought to be giants in the industry were and continue to be vulnerable, and cannot ignore volatile market conditions and escape the fundamental principles of sound underwriting guidelines and adequate risk control.

With conditions expected to worsen in the coming months, further fallout can be expected. Those companies that are large enough and strong enough, or those fortunate enough to have a deep-pocketed investor or parent company, will survive and benefit from the reduced competition once this cycle turns.

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, and Byron Nelson, an associate at Deloitte & Touche Corporate Finance LLC, contributed to this article. Deloitte & Touche Corporate Finance LLC (D & TCF), member NASD, is a wholly owned subsidiary of Deloitte Financial Advisory Services LLP.

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.

Figure 1 Select Mortgage Banking Deals in 2007

Buyer               Target

Lone Star Funds     Accredited Home Lenders
Ellington           Fremont General Corp. subprime business
  Management
  Group LLC (1)
Impac Mortgage      Pinnacle Financial Corp.
  Holdings
Cerberus Capital    Option One Mortgage Corp.
  Management LP
Carrington Capital  New Century servicing and platform
  Management LLC
General Electric    PHH Mortgage
  Co./Blackstone
  Group LP (2)
Citadel Investment  ResMAE Mortgage Corp.
  Group LLC
Citigroup Inc. (3)  ACC Capital wholesale platform and servicing
                    platform
C-BASS              Fieldstone Investment Corp.
Indymac Bancorp     Retail mortgage platform of New York Mortgage Trust
  Inc.
Citigroup Inc.      ABN AMRO Mortgage Group Inc.
Barclays PLC        EquiFirst Corp.

                                             Servicing
                    Announce   Deal Value    Volume        Originations
Buyer               Date       ($ millions)  ($ millions)  ($ millions)

Lone Star Funds     6/4/2007   $400          NA            $15,700
Ellington           5/22/2007  NA            $24,400       $32,300
  Management
  Group LLC (1)
Impac Mortgage      5/21/2007  NA            NA            $5,000
  Holdings
Cerberus Capital    4/20/2007  $969          $71,000       $27,400
  Management LP
Carrington Capital  4/2/2007   $188          $40,800       NA
  Management LLC
General Electric    3/15/2007  $1,690        $160,222      $41,260
  Co./Blackstone
  Group LP (2)
Citadel Investment  3/5/2007   $182          $3,100        $7,700
  Group LLC
Citigroup Inc. (3)  2/28/2007  NA            $65,000       $23,000
C-BASS              2/15/2007  $188          $6,163        $5,697
Indymac Bancorp     2/6/2007   $13           NA            NA
  Inc.
Citigroup Inc.      1/22/2007  NA            $229,900      $27,500
Barclays PLC        1/19/2007  $225          NA            NA

(1) Fremont announced the sale of its servicing platform and subprime
business to an undisclosed buyer on April 16, 2007.
(2) General Electric Co. acquired PHH and spun off the mortgage division
to Blackstone Group LP.
(3) Citigroup has the option to acquire the servicing and wholesale
division of ACC. The option is for nine months and is subject to
achieving business milestones, regulatory filings and approvals.
SOURCE: SNL FINANCIAL