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Bad loans, especially subprime, draw bad blood

As the housing sector cools, the mortgage market faces an awkward question: Who takes the hit when loans go bad?

A generation ago, nobody asked. Banks made loans and suffered the consequences when borrowers didn't pay. Today, a complex Wall Street machine buys and sells mortgages and packages the loans into securities that are diced and sliced and sold again to investors worldwide.

Although the $9.1 trillion mortgage market has been relatively calm as the housing market has slowed, players on Wall Street and beyond are starting to grapple over bad loans, especially in the market for borrowers with scuffed credit -- so-called subprime customers.

Under contracts that govern the exchange of mortgages, lenders often must take back loans that default very early in their lives or that come with underwriting mistakes, such as flawed property appraisals. As the housing boom fizzles, cases of bad underwriting are popping up and more mortgages are defaulting early. That has investment banks and other mortgage buyers invoking these contract provisions and pressing lenders to repurchase mortgages that get sold to third parties, creating big losses for some lenders.

In response, some of the loan originators are tightening their underwriting standards. Investors and lenders also are doing more financial sleuthing to sniff out problems in loans.

H&R Block Inc. (NYSE: HRB) recorded a $131 million loss for the quarter ending July 31, largely because it added $102 million to reserves for loans its unit Option One Mortgage Corp. had to repurchase. In August, Fremont General Corp. of Santa Monica, Calif., said it was dropping or scaling back on some low-down-payment loans and on some loans to subprime customers to reduce mortgage buybacks. Bear Stearns Cos. (NYSE: BSC) and other companies are suing lenders that they claim passed on bad mortgages that quickly defaulted.

"In a rising market, even a bad loan is a good loan," said Nate Redleaf, a research analyst with Imperial Capital LLC, a Beverly Hills, Calif., investment bank. "You could be sloppy and it didn't matter. Now people really have to do their jobs. They have to be more vigilant."

Mortgage repurchases aren't always reported, so it is unclear how many loans are being sent back to their lenders, or their total value. A study by Credit Suisse Group found evidence of a jump in the subprime market. It examined 208 bond deals involving pools of subprime mortgages totaling $234 billion. The study found nearly half of these mortgage pools had some loans repurchased in the first quarter of 2006, up from less than a third that faced repurchases in 2005. The dollar value of repurchased mortgages has been small -- well under 1 percent of the total value of mortgages in the pools with at least one repurchase -- but it also climbed, the study found.

It is unclear whether the recent round of mortgage hot potato represents a fine-tuning of the system that helped create the largest mortgage boom in history or the beginning of a more serious shakeout.

While "not serious" at this point, the buybacks are the first real test of the modern mortgage market, said Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School. "This will continue to be an issue even in the case of a soft landing" in real estate, he said.

Of the $3.1 trillion in mortgages originated last year, 68 percent were packaged into securities, Bear Stearns said. In the past, most mortgages rolled into securities were standard loans packaged by government-chartered loan clearinghouses Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Investment banks increasingly have gotten in on the action, and they have helped fuel the growth of atypical mortgages, including risky ones that don't require down payments or income documentation.

"You had a well-oiled machine," said Thomas Lawler, a former Fannie Mae economist and now a consultant. As loan volume declined in 2005, lenders got "a little more creative" and loan quality declined.

Credit Suisse estimates early defaults more than doubled between the first quarter of 2004 and the first quarter of 2006 on subprime loans that didn't require income documentation.

The current round of loan buybacks began in late 2005 and picked up steam in 2006. It probably will continue for several more quarters if mortgage delinquencies keep rising. "When you see foreclosures rise, you often see buybacks rise," said Doug Duncan, the Mortgage Bankers Association's (MBA) chief economist. He expects a modest increase in delinquencies in the next year or two.

Mortgage delinquencies have been at historically low levels, and the perceived riskiness of mortgage-backed securities -- as measured by their yields compared with all-but-risk-free Treasury bonds -- has been relatively stable. Overall delinquency rates on mortgages edged up in the second quarter from a year earlier, with the biggest increases in adjustable-rate loans, according to the MBA.

Investment banks and others are showing an unwillingness to wait for loans to default before taking action. Some are turning to companies such as Clayton Holdings Inc., which uses computer-driven risk models to find troubling patterns, such as brokers that sold lots of bad loans. Mortgage investors and lenders are "sharpening their pencils and using a thicker magnifying glass," said Keith Johnson, Clayton's president.

Early defaults helped account for Option One's spike in loan repurchases. H&R Block chief executive Mark Ernst told stock analysts in an Aug. 31 conference call that investment banks have been especially aggressive at pushing back early default loans, rather than holding on to them with hopes that borrowers would start paying, as the banks might have done in the past.

"We experienced a significant and unanticipated increase in loan-repurchase requests from investors as first payment defaults accelerated," Ernst said in the call.

Impac Mortgage Holdings Inc., a Newport Beach, Calif., real-estate investment trust that earned $270 million last year, saw repurchases triple between the first and second quarters of this year, rising to about $100 million. Impac said its repurchases peaked in the second quarter.

When loans go bad, both the original lender and the current owner have an incentive to resolve the issue quietly: Lenders need to be able to sell their loans, and investment banks need loans to bundle together and sell as securities. In some cases, however, disputes are winding up in court.

In a lawsuit in U.S. District Court in Dallas, Bear Stearns's EMC Mortgage Corp. unit is suing MortgageIT Holdings Inc., New York, in an attempt to force it to buy back at least 587 loans totaling $70 million. The lawsuit alleges MortgageIT failed to repurchase defaulted loans, as required by sales contracts. MortgageIT, which is being acquired by Deutsche Bank AG, denies the allegations in court papers and vowed in a securities filing that it will "vigorously defend" itself. Representatives for Bear Stearns and MortgageIT declined to comment.

EMC was among 11 lenders that unsuccessfully sought more than $20 million in loan repurchases from a Belleville, N.J., lender, D&M Financial Corp., which is in bankruptcy-court proceedings. A lawsuit filed by EMC in federal court in Brooklyn accused D&M of a wide-ranging scheme involving "vastly inflated" appraisals and altered or forged down-payment checks.

Saul Berkman, an attorney for D&M, said its executives denied the fraud allegations. He added the company has little or no assets left to fund repurchases.

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