Sub-Prime Time

They are the Felix Unger and Oscar Madison of the home loan business.

Pasadena-based Countrywide Home Loans Inc., a respected player in the buttoned-down world of mortgage lending, has catered primarily to borrowers with squeaky-clean credit. Aames Financial Corp. of Los Angeles, on the other hand, has thrived in the hard-nosed, hard-sell business of loaning money to customers with credit problems.

Now, however, both Southern California lenders find themselves competing in the same market. Faced with thinning profit margins and intense competition in the conventional mortgage business, Countrywide has moved into the high-risk, high-profit territory of the home loan business dominated by companies like Aames.

“It’s a gigantic market out there,” said Joe Harvey, president of Countrywide’s new Full Spectrum division, which makes home equity and purchase loans to customers who would have been turned down under Countrywide’s conventional standards.

Last year, sub-prime lenders generated an estimated $100 billion to $150 billion in home loans--primarily home equity loans, according to various industry estimates. That’s far smaller than the estimated $800 billion in conventional mortgages, but the volume of subprime home loans grew more than twice as fast, according to SMR Research Corp., a New Jersey-based research firm.

“The lenders are getting squeezed because you have overcapacity and very aggressive competition in the [conventional mortgage] market,” said financial industry analyst Thomas O’Donnell at Smith Barney. “There is a vast market that’s untapped. So why not move into that one as well and find new customers?”

Not everyone, however, is cheering the push by Countrywide and other conventional lenders into the risky end of the loan industry. Consumer groups fear that the growth of home equity loans--a specialty of sub-prime lenders--will bury consumers under even more debt. The new entrants could also risk their financial health as well as their reputation by failing to prepare for the market’s harsh realities and practices.

“In the sub-prime business, you are in the collection business,” said Gary Judis, longtime chairman of Aames Financial, corporate parent of industry pioneer Aames Home Loan. “There is a cultural transition [by newcomers] that has to be accomplished. It takes many years.”

As Full Spectrum expands, it will have to overcome the same challenges facing Aames and other industry players. Many lenders, for instance, have cut their fees and their fat profits as the competition for the most credit-worthy borrowers in the sub-prime field has intensified. Rising levels of consumer debt, credit delinquencies and personal bankruptcy could also undermine the ability of borrowers to pay back their costly loans.

The field’s growth and profitability, however, have outweighed the potential risks for newcomers, said Roger W. Merritt, a mortgage banking industry analyst at Fitch Research. “I think there is still a significant amount of untapped potential in the market as a viable alternative to other forms of consumer debt and credit cards,” he said.

Countrywide’s presence in the market also illustrates the newfound respectability of sub-prime lending, where high interest rates and the strong-arm collection tactics of some finance companies have long tainted the business. Many of the players are still referred to as “hard money” lenders.

But investors now snap up billions of dollars in securities backed by pools of sub-prime home loans. Wall Street has responded enthusiastically to the public stock offerings of several sub-prime lenders, such as Aames, which outperformed the shares of many traditional banks.

Aames, which listed its shares on the New York Stock Exchange in 1992, has expanded rapidly in part by acquiring other sub-prime players, including One Stop Mortgage Inc. of Costa Mesa. The company has also souped up its loan volume and profits by buying loans from mortgage brokers and reselling them to investors. Under that strategy, Aames’ loan volume has jumped from about $150 million to nearly $1 billion in about three years.

“The industry was not viewed as very credible,” said Aames’ Judis, who points out that his firm has helped customers finance start-up firms and consolidate and pay off high-interest rate debt. “It’s a rather arrogant and smug view that society takes” of sub-prime lenders and their customers, he said.

Delving into such a business worried many employees at image-conscious Countrywide, said Harvey. “They were worried because we had such a good reputation in the ‘A’ world.”

The “A world” that Harvey refers to is made up of conventional lenders that deal almost exclusively with customers whose employment, financial and credit histories are relatively trouble-free. Below that, sub-prime lenders pick up the customers rated A-, B, C and D whose credit has been tarnished by late payments, bankruptcy, default or unemployment.

“It’s a very different market,” said Michael Abrahams, a financial industry analyst for Sutro & Co. “A lot of the borrowers have incomplete credit histories and their work history may be checkered. But it may be still a great loan.”

Sub-prime loans suffer from high rates of delinquencies and default, but higher interest rates and greater scrutiny by the lender can offset the losses and generate high profits. A home buyer with good credit, for example, could expect to get a fixed-rate, 7.5% mortgage. The same loan would cost a C-rated borrower an 11% to 12% interest rate and require higher levels of equity--to protect the lender in case of default--than the more credit-worthy customer.

“Most people that take those loans are in a jam,” said mortgage broker Steve Abo. “People might have jobs, but they are still dealing with [credit and financial] problems from a few years ago. There is a demand for it.”

Mario, an unemployed carpenter from Glendale, was in danger of losing his family’s home after falling several months behind on his mortgage payments. After his mortgage lender refused to work with him, the 55-year-old carpenter turned to Full Spectrum to refinance his mortgage, which allowed him to pay off other debts and catch up with his house payments.

After two years at a fixed rate, the loan becomes adjustable and can rise as high as 16%. Despite such a high ceiling, Mario gladly took the loan, which he said had more attractive rates than those from other lenders.

“They actually helped [keep] us from losing the house,” said Mario, who did not want his last name used.

But consumer advocates worry that the rising use of sub-prime home equity loans will only give many people the opportunity to sink deeper into debt.

“Some people who consolidate their credit card debt have already gotten into a pattern of not managing their own budget and their own debt,” said Hernandez of Consumers Union. “They take out this loan and down the line they get into more debt.”

But Countrywide remains undeterred, opening seven Full Spectrum offices in recent months and planning an “aggressive” expansion, said Harvey. Customers who fail to meet Countrywide standards are referred to Full Spectrum, which has hired away experienced employees from established subprime lenders to help handle the new customers.

“You try and negate the risk by hiring the right people,” said Harvey, who had also worked for a sub-prime lender before joining Countrywide 11 years ago.

Countrywide and other newcomers threaten to increase the competition and narrow the fat profits long enjoyed by Aames and its peers. But after 30 years in the business, Aames--which operates more than 50 branch offices--has developed the brand name and experience to survive and avoid the pitfalls some of its new rivals will face, said Abrahams of Sutro & Co.

“A lot of these new entrants are going to have their heads handed to them,” he said.

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How Do You Rate?

The most credit-worthy customers--those rated A--would have few problems getting a home loan from most banks and conventional lenders. Sub-prime lenders serve borrowers with lower credit ratings.

Rating / Description

A-

* Bills of $500 or less turned over for collection within last two years

* No more than two 30-day-late payments or one 60-day-late payment on credit or installment credit within last two years

B

* Up to four 30-day-late payments on revolving and installment credit within last 18 months

* Bankruptcy or foreclosure has been resolved 18 months before loan application

C

* No more than six 30-day-late payments within last 12 months on revolving or installment credit

* Current collection accounts of less than $4,000 paid in full before loan is approved

* Bankruptcy or foreclosure has been resolved 12 months before loan application

D

* Sporadic disregard for timely payment and credit record

* Current collection accounts and judgments paid off with loan proceeds

* Home foreclosure or bankruptcy settled six months before loan application

Source: Mortgage Market Information Services