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In Home-Lending Push, Banks Misjudged Risk

HSBC Borrowers Fall Behind on Payments
Hiring More Collectors

CARRICK MOLLENKAMP / Wall Street Journal 8feb2007

 

When the U.S. housing market was booming, HSBC Holdings PLC raced to join the party. Sensing opportunity in the bottom end of the mortgage market, the giant British bank bet big on borrowers with sketchy credit records.

Such subprime customers have always been risky, but HSBC figured it could control that risk. In 2005 and 2006, it bought billions of dollars of subprime loans from other lenders, lured by the higher interest rates they carry.

Now, the party is over for HSBC -- and for lots of other bankers who aimed to cash in on the housing boom of the first half of this decade. When interest rates ticked up and the market cooled, HSBC reached a disconcerting conclusion: Its systems for screening subprime borrowers and for assessing the default risk they posed were flawed.

Many of those loans have soured, sometimes quickly. The percentage of HSBC mortgages more than 60 days past due is climbing. Fraud by borrowers has been higher than expected. "We made some decisions that could have been better," says Tom Detelich, the HSBC executive in the U.S. spearheading an effort to clean up the mortgage portfolio.

In a surprise announcement late yesterday, HSBC said its subprime-mortgage problem was worse than previously indicated. It said the capital it sets aside to cover all bad debts, including the soured mortgages, would be 20%, or $1.76 billion, higher than analysts' consensus estimates. "The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. subprime mortgage market, particularly in the more recent loans," the bank said.

HSBC's mortgage woes provide a window into the economic hangover brought on by the end of the housing boom. In recent months, mortgage bankers have taken a place beside home builders, condominium developers and real-estate agents, all of them struggling to adjust to a new housing landscape.

London-based HSBC, the world's third-largest bank by market value and one of the biggest subprime lenders in the U.S., is one of several lenders to stumble in its dealings with low-end borrowers. Subprime mortgage lending surged over the past several years, and these days, subprime mortgages comprise about 12% of the roughly $8.4 trillion U.S. mortgage market, up from 7.5% of the market in late 2001, according to First American LoanPerformance, a San Francisco research firm.

Seattle-based Washington Mutual Inc. said last month that its subprime mortgage portfolio suffered in the fourth quarter. Four smaller mortgage lenders from which HSBC bought loans have disclosed problems: Carrollton, Texas-based Sebring Capital said that as of Dec. 1 it had ceased operations and was no longer accepting loan applications; Ownit Mortgage Solutions Inc. of Agoura Hills, Calif., filed for bankruptcy-court protection just after Christmas; and Fieldstone Investment Corp. and Accredited Home Lenders Holding Co., both public companies, have reported disappointing financial results.

HSBC is working to contain the damage and to persuade investors that it has learned from its mistakes. It has hired more people to seek payments from borrowers and has installed an executive schooled in workouts at the worst-hit division, HSBC Mortgage Services.

The troubled subprime mortgages represent only a small slice of HSBC's overall consumer-loan portfolio. But some analysts attribute the poor performance of HSBC's stock to the weakness of its U.S. consumer-finance operations. Over the past year, its shares have been flat in London trading, while the Dow Jones Wilshire Global Banks index has risen 19%.

HSBC, a 142-year-old bank with operations in 76 countries and territories, got into the U.S. consumer-finance business in 2003 with its $14 billion purchase of Household International Inc. Household, a big subprime lender based in Prospect Heights, Ill., had been criticized for allegedly predatory lending practices and, shortly before the HSBC deal, had reached a $484 million settlement with state regulators. HSBC saw Household as a way to diversify beyond Europe and Asia, and viewed subprime mortgage lending as a far less competitive business than lending to more credit-worthy customers.

After the deal was announced, Household's then-chief executive, William Aldinger, bragged that Household employed 150 Ph.D.s skilled at modeling credit risk. Household had developed a system for assessing consumer-lending risk -- called the Worldwide Household International Revolving Lending System, or Whirl -- which it used to underwrite credit-card debt and to collect from consumers in the U.S., United Kingdom, Middle East and Mexico.

Complicated Web

The mortgage market in the U.S. is a complicated web of mutually dependent businesses. Mortgages are frequently bought and sold several times over, and the default risk often lands far from the institution that originated a mortgage. Banks and mortgage brokers size up would-be borrowers and make the loans. These lenders sell many of the loans to mortgage wholesalers, which gather them into pools and flip them to large financial institutions or banks like HSBC. Some of these buyers, including Wall Street investment banks, package the mortgages as securities for sale to investors, a process known as securitization.

HSBC Mortgage Services, a South Carolina-based arm of the bank, was active in several parts of this web. One unit, called Decision One Mortgage Co., originated mortgages, many of them to subprime borrowers. HSBC sold some of these loans, but it held others as investments, collecting the interest income they generated and shouldering the risk of loss if they soured.

But the old Household branch network didn't reach everywhere, and HSBC was eager to boost the size of its mortgage business quickly. So it became a big buyer of subprime loans originated by others, which it held in its own portfolio. It purchased loans from approximately 250 wholesale mortgage companies, which themselves bought the loans from independent brokers and banks.

In 2006, the main operations of HSBC Mortgage Services moved from Charlotte, N.C., to a new Fort Mill, S.C., facility, which HSBC said offered 60% more space to accommodate expected growth. The unit also added to its mortgage-processing staff in Florida.

HSBC focused on buying second-lien loans. Also known as piggyback loans, they allow home buyers who are unable to scrape together down-payment money to borrow it. By cobbling together a bigger first mortgage from one lender and a second-lien loan often from another, home buyers can borrow 100% of the purchase price of a home. In the event of default, the first-mortgage lender has first claim on the property, which leaves the second-lien lender in a riskier position. For that reason, second-lien loans carry higher interest rates -- making them potentially more lucrative for lenders.

HSBC bought lots of mortgages. It was the top buyer of loans from Fieldstone Investment in Columbia, Md., a large mortgage originator. According to Fieldstone's securities filings, HSBC bought Fieldstone mortgages with a face value of $1.2 billion in 2005. By March 2006, the second-lien loans on HSBC's balance sheet totaled $10.24 billion, up from $6.3 billion in September 2005.

Bobby Mehta, HSBC's top executive in the U.S., said the bank was building its mortgage portfolio in a disciplined manner. "We've done them conservatively based on analytics and based on our ability to earn a good return for the risks that we undertake," he told investors in May 2005.

Tricky Business

Assessing the quality of big mortgage pools and predicting how many of the loans will go bad is a tricky business. Typically, HSBC would first specify to a mortgage wholesaler what kind of loan pool it was looking for, based on the income and credit scores of borrowers. Then it would send in its analysts to review the portfolio.

Zan Hamilton, chief executive officer of Lime Financial in Oregon, says his mortgage origination firm got used to having HSBC employees hunched over their computers sorting through mortgages for sale, trying to ensure they met HSBC's standards.

Some decisions later proved to be mistakes. To speed up these purchases from other lenders, HSBC accepted loan paperwork that didn't verify whether borrowers made as much as they claimed. Mortgages that rely on the borrower's word about that are called "stated-income" loans. (More conservative lenders might demand full documentation of income.)

As the real-estate market boomed in recent years, subprime loans were in hot demand by Wall Street banks and other investors, thanks to the higher interest rates paid by subprime borrowers. This competitive market prompted HSBC and others to seek riskier loans from less credit-worthy borrowers.

Lenders typically base their calculations of a borrower's credit-worthiness on credit ratings known as FICO scores, which are generated by Fair Isaac Corp. of Minneapolis. FICO scores are used to assess applicants for credit cards, auto loans and fixed-rate mortgages, among other things.

But FICO scores had not yet been put to the test in predicting the performance, during a weakening housing market, of second-lien loans taken out by subprime borrowers. The same was true for adjustable-rate mortgages to subprime borrowers, which HSBC also purchased.

"There was very little data on loans to subprime borrowers where the borrower put very little down," says Thomas Lawler, a housing economist in Vienna, Va.

Chris Freemott, president of All American Mortgage Inc. in Naperville, Ill., says it was a time when "everyone lowered their credit standards" in what he refers to as "a race to the bottom." Adds Mr. Hamilton at Lime Financial: "People got way too aggressive in pricing, and they weren't pricing for the risk."

HSBC acknowledges that it erred in the way it assessed such subprime mortgages. "What is now clear is that FICO scores are less effective or ineffective" when lenders are granting loans in an unusually low interest-rate environment, Douglas Flint, HSBC's finance director, told investors in December. A spokesman for Fair Isaac says the company simply provides credit scores, and it is up to lenders to decide how to use them.

In 2005, HSBC stepped up its mortgage buying. By early 2006, interest rates were rising and home-price appreciation was slowing. The rate increases made it difficult for some borrowers to lower their monthly payments by refinancing, one way that borrowers in a financial pinch try to avoid default.

Some of HSBC's loans turned bad swiftly. Cynthia Soto and her husband Frank got a second mortgage from HSBC in May 2005 on their Grove City, Ohio, home. Ms. Soto, now 53 years old, says she was struggling with disabilities connected to heart troubles, and that she needed a kidney removed. Her husband works at an auto-parts plant. The Sotos wanted the money to pay off credit-card debt.

Second mortgages can be risky for lenders, because the first-mortgage lender has first claim on the home in event of default. Just one year after getting the $32,000 loan, the Soto's filed for Chapter 13 bankruptcy protection. "After raising three kids and having to come down to that, it was pretty hard," Mrs. Soto says. In bankruptcy-court documents, the Sotos, whose first mortgage is also with HSBC, maintained that there isn't enough equity in their 39-year-old home to cover the second HSBC loan.

Loans that HSBC purchased from other originators also began going bad. HSBC, for example, held the mortgage on Radames Mendez Jr. and Shana Ramos's Pennsylvania home. Bay Capital, a Maryland lender, had made the loan in June 2005, then transferred it to HSBC, according to federal court records. By April 2006, the borrowers had fallen behind on their payments, according to a complaint HSBC filed last September, seeking payment of $170,718.02 in principal due on the mortgage. In court papers, a local sheriff said he'd been unable to locate the couple to serve them with the foreclosure papers.

Mortgage lenders expect to see delinquencies and defaults climb in such an environment, and they plan for it. But by early 2006, HSBC was seeing indications that delinquencies were going to be worse than expected.

At first, HSBC executives say, the bank thought the defaults were tied to a change in U.S. bankruptcy laws in 2005, which prompted a spike in bankruptcy filings by consumers. But after a few more months of data rolled in, HSBC officials concluded they had a broader problem.

Last August, HSBC issued a memo to companies from which it was buying loans. The paper, called "Threads of Early Payment Default," reported that delinquencies were rising. HSBC said mortgage lenders had seen "a wealth of surprising data" on loans originated in 2005, including "surges" in 60-day-past-due delinquencies, particularly on "borrower-friendly" second-lien loans, and "heightened fraud incidents."

When borrowers didn't have to verify their incomes, the report said, they were overstating them, and they bolstered their false claims by overstating their job positions. HSBC recommended that originators verify employment by phoning human-resources departments and asking questions such as: "How many years has John worked there?" and "What is his title?"

HSBC has told investors that its second-lien loan portfolio represents just 6% of HSBC Finance Corp.'s $177 billion U.S. consumer-loan portfolio, which includes mortgages, auto loans and credit-card receivables. The percentage of loans in that larger pool that are 60 days or more past due rose to 3.99% at the end of September, from 3.57% three months earlier.

Limiting Damage

HSBC is trying to limit the damage. Last August, it installed a new head of HSBC Mortgage Services: Mr. Detelich, who had overhauled HSBC's U.S. consumer-lending business after Household's 2002 predatory-lending settlement with state regulators.

HSBC doubled to 875 the number of employees in Tampa and nearby Brandon who contact customers about missed payments and try to work out payment plans. That operation now runs seven days a week. HSBC is using computers to try to identify borrowers who will have the most trouble making monthly payments after their adjustable-rate mortgages, or ARMs, adjust upward.

This year is expected to be particularly tough for some holders of adjustable-rate subprime mortgages. Holders of ARMs originated in 2005 and 2006 and that reset after two years could face monthly payment increases of as much as $500, according to Fitch Ratings. That could mean more trouble for HSBC, which holds many such loans.

HSBC is hiring "ARM modification specialists" in Tampa to help troubled borrowers. The bank says it is willing to stop short of jacking up rates as much as it is entitled to if that would help borrowers avoid default -- but only case-by-case.

The bank has stopped making and buying loans where borrower income hasn't been verified, and it has raised the FICO scores needed for certain loans. "Ensuring the customer can make payment is good for us and good for the customer," says Mr. Detelich.

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