39.5 percent delinquency rate? Bring it

The demise of Bear Stearns has the Fed looking for new ways to help lenders and investors holding deteriorating mortgage-backed securities borrow money against them instead of selling them at fire sale prices (see story).

Periods of dramatic change (calamity?) also create opportunity left and right. That's why Bank of America thought Countrywide Financial would make a nice meal (the jury is still out on that one), and why you keep hearing about billionaire Warren Buffet's attempts to scoop up a big chunk of the bond insurance business.

The latest play by billionaire Wilbur Ross to carve a space in subprime loan servicing is another example of a seemingly contrarian move that, if you're looking for some light at the end of the credit crunch tunnel, might seem at first glance like good news. By moving to buy Option One Mortgage's $54 billion in mortgage servicing rights, Ross is positioning himself to be the nation's second biggest subprime loan servicer, behind Countrywide (see story).

But that doesn't mean Ross thinks the loans themselves are good investments. He just thinks he can make lots of money on the fees he will charge the lenders and investors who actually own the loans for collecting payments from borrowers on their behalf.

A big part of the equation for Ross and others who do this kind of thing is how long the loans in their servicing portfolios will continue to generate revenue. The danger for servicers is not so much foreclosure (they make some money when loans go bad, too) but prepayment risk -- that borrowers will sell their homes or refinance their loans with some other lender.

Ross may be thinking that the subprime borrowers whose loans he's forking out nearly $2 billion for the right to service won't be able to sell their homes or refinance as easily as they could during the boom. If he gets enough loans together -- he's rounded up something on the order of 500,000 so far -- he'll have some economy of scale that can make this a profitable business (especially owning Option One's call center in India).

But if you were thinking that Ross's play for Option One's servicing business was a vote of confidence in the future performance of subprime loans, think again. The terms of the deal provide some insight that might lead you to believe the opposite.

There's a clause in Ross's agreement with Option One that says if 30-day delinquencies in the servicing portfolio rise above 38.5 percent before April 30 (or 39.5 percent after May 1), the purchase price gets cut -- by $20 million for the first 1 percent over the threshold, and $10 million for each percentage above that.

Pocket change in a $1.1 billion deal, maybe, but wait a second: Did they say the 30-day delinquency rate on Option One's servicing portfolio could hit 38.5 percent by the end of next month? Wasn't it 24.4 percent at the end of 2007? And 11.2 percent at the end of 2006?

Does that make you wonder about Standard & Poor's call last week that we've seen the majority of subprime write-downs?

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