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.In our first four months, it representednearly 40 percent of our business.It had the two things every sub-prime wholesale lender wanted a unique niche and a high mar-gin.Given the absurdity of the product, it seemed only fitting thatthe first mortgage we ever closed, which fit its guideline, went toforeclosure less than a year later.There was nothing fraudulent ordeceptive about the deal.It was just a high-risk loan based on aflawed risk model.The product offering was short lived.When Citigroup purchasedThe Associates, they immediately discontinued the program.Sometime later, a colleague confirmed what many of us had already ex-pected the product performed poorly.Another profound lapse in judgment occurred in 2003 when RFCoffered 100 percent financing for borrowers with 560 credit scores.Until that point, it was generally accepted that 580 was the minimumscore.Writing a 100 percent loan with a 560 score was like swimmingwith sharks it was only a matter of time until you were bitten.At Kellner we viewed RFC s program as a desperate act.Alwaysthe conservative stalwart, RFC seldom pushed the risk envelope.When I worked for them in 1998, one of their more unusual prod- ccc_bitner_127_150_c06.qxd:ccc_bitner_c06_127_150.qxd 5/29/08 1:44 PM Page 143The Demise of the Industry 143uct offerings was a 125 percent loan, which was a second-lien mort-gage that allowed consumers to borrow up to 125 percent of thevalue of their homes.When this industry segment imploded, RFCwas the only major investor left standing.They built a reputationas a smart and conservative company because they understood howto manage risk.When the Wall Street investment banks started capturing alarger share of the subprime market, RFC quickly fell behind.In afew years they went from being a top five investor to barely makingthe top 20.The 100 percent product was intended to help them re-claim market share.Offered only to select customers, the product proved to be a disas-ter.Seldom in the history of mortgage lending had a new productbeen so quickly pulled from the market.It showed how the pressure tocompete for market share could wear down even the smartest lenders.This should have sounded some alarm bells.If a company widelyregarded as the leader in managing risk for nonagency mortgagesexperienced such a profound lapse in judgment, how would other,less-skilled investors respond to the pressure?Profit MarginsFrom 2000 to 2002 we were paid between 450 to 500 basis points(bps) for each loan sold.In some cases the figure exceeded 500 bps, asevidenced by The Associates example, but that was the exception.By 2003 we started experiencing a marked decline in profitability.With over 100 subprime wholesale mortgage companies competingfor business, lenders grew volume at the expense of profit margin.Table 6.1 shows what happened to our profits from 2003 through2005.The numbers are strictly for illustration purposes and don trepresent actual revenue.The first year serves as a baseline with100 loans equaling $100 in revenue.This chart shows how the fol-lowing years stacked up relative to 2003.It doesn t take a Whartongraduate to realize the business model was headed for disaster.Al-though volume was growing, net revenue per loan was dropping ccc_bitner_127_150_c06.qxd:ccc_bitner_c06_127_150.qxd 5/29/08 1:44 PM Page 144144 Secondary ContributorsTable 6.1 Net Revenue ComparisonsNumber of Loans Total Revenue Revenue per Loan2003 100 $100 $1.002004 145 $75 $0.552005 210 $50 $0.30fast.Even though expenses increased as result of growing the busi-ness, the decline was largely a result of being paid less for the prod-uct.Conversations with our competitors indicated they wereexperiencing a similar trend.Several things contributed to this decline.First, the largest sub-prime lenders started a price war.Companies like New Century andArgent offered rates that weren t compatible with the risk levels.We tried to win customers by offering stellar service and for a whileit worked.But once technology leveled the playing field, our com-petitors improved their service.We had to shrink our profit marginsto remain competitive.The pricing pressures meant small and medium-sized lenderswere hit the hardest.The same investors who purchased our loanshad wholesale divisions that undercut our pricing.Since thebiggest lenders put loans directly into a security, their margins werehigher, which enabled them to compete better in a price war.As apass-through lender, another layer in the food chain, we didn thave that luxury.Second, it s no coincidence our revenue peaked just as the fedfunds rate bottomed out.While that indicator doesn t dictate fixedmortgage rates, it influences the overall cost of money, which im-pacts interest rates for ARMs.Keep in mind that most subprimeloans are adjustable rate, not fixed.Kellner s ARM to fixed productratio was 80/20, similar to most of our competitors.As the Fed in-creased the funds rate by more than 4 percent from 2004 to 2006,interest rates for subprime ARMs remained flat.The only way forrevenues to keep pace was to increase loan production. ccc_bitner_127_150_c06.qxd:ccc_bitner_c06_127_150.qxd 5/29/08 1:44 PM Page 145New Products A Meltdown of Epic Proportions 145Watching this scenario unfold, I realized the industry was losingtouch with reality.I frequently spoke with a colleague and com-petitor who owned Concorde Acceptance Corporation and wewould talk about the state of the industry.We often discussed therisk-reward curve, which helped analyze the effectiveness of ourbusiness model.By late 2004 we both felt the business hadreached a point where the risk of being a wholesale subprimelender outweighed the financial rewards.Rational thinking dictates that when the cost of money goes up,interest rates should follow.While some reduction in margin is ac-ceptable and expected in a highly competitive market, the leadingsubprime companies took it to the extreme.Unfortunately, as mar-gins were getting squeezed, the most critical factor was being ig-nored risk.At a basic level, mortgage lending is nothing more than effectiverisk management.If a lender offers a high-risk product and profitmargins continue to drop, one of two things must happen.Thelender either increases interest rates or tightens underwriting guide-lines to compensate for the reduced margin and subsequent risk.Not only did the industry choose to ignore both principles, it wentin the opposite direction by developing more aggressive products.New Products A Meltdown of Epic ProportionsIf the subprime industry was teetering on the edge of a cliff, relaxedunderwriting standards pushed it over the edge.Before discussingthe particulars, here is a quick recap of the events leading to the in-dustry s demise." With the advent of the piggyback mortgage and the neutraliza-tion of mortgage insurance companies and government-sponsoredenterprises, investment firms and rating agencies were left toregulate the industry." Interest rates fell to record lows, creating a frenzy among con-sumers to acquire investment properties, treat their homes like ccc_bitner_127_150_c06.qxd:ccc_bitner_c06_127_150.qxd 5/29/08 1:44 PM Page 146146 Secondary ContributorsATM machines, or achieve the American dream by owning ahome regardless of whether they could afford it." By 2003 brokers were originating the majority of all subprimeloans.By 2006, the figure peaked at 63 percent.With many loanofficers new to the business, this unregulated and unsupervisedgroup of originators took a bad situation and made it worse
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