Feb. 12 (Bloomberg) -- Merrill Lynch & Co. Chief Executive Officer Stanley O'Neal was willing to lose $230 million to catch Bear Stearns Cos. and the shakeout is just beginning.

That's because Merrill is determined to capture a dominant share of trading in bonds backed by home loans, the fastest- growing debt market since 1995 and this year's most troubled. O'Neal's enthusiasm for mortgages to potentially delinquent borrowers coincides with the highest default rate in more than six years, a record contraction in demand for so-called subprime loans and descending bond prices.

Merrill already has bankrolled two home lenders that subsequently failed and purchased a third, First Franklin Financial Corp., for $1.3 billion, just before HSBC Holdings Plc disclosed that its bad-loan provisions increased 20 percent because of the unraveling U.S. subprime market.

``You've got to remember'' that New York-based Bear Stearns, the perennial leader in mortgage bonds with only a quarter of Merrill's 56,000 headcount, ``got into this business at the height of the boom, when you could not lose,'' Angelo Mozilo, Countrywide Financial Corp.'s CEO, said in a telephone interview from his office in Calabasas, California.

``The real test will come for these new players in how they do in this new cycle,'' Mozilo said. ``A couple may do fine and a couple won't do fine. Just because it's Wall Street and they've got into the origination business doesn't mean they automatically win.''

Fees Tripled

New York-based Merrill, the third-largest securities firm by market value, isn't the only challenger to No. 1 Bear Stearns. Deutsche Bank AG, Morgan Stanley and Barclays Plc have bought or agreed to buy subprime lenders in the past six months, betting that a bigger presence in mortgages will produce more revenue from packaging the loans into bonds.

Fees from securitizing debts including mortgages, auto loans, aircraft leases and credit-card receivables have almost tripled in the past five years to $5.6 billion, Bank of America Corp. analyst Michael Hecht estimates.

Bear Stearns was the top seller of mortgage bonds in 2006, its third year in first place, followed by Royal Bank of Scotland Plc's RBS Greenwich Capital Markets and Lehman Brothers Holdings Inc., according to data compiled by Bloomberg. The rankings don't include subprime deals.

Merrill is counting on securitization to dispose of risky mortgages and avoid the headaches now plaguing HSBC, the world's third-largest bank. The London-based company on Feb. 7 increased the amount set aside for bad loans in 2006 to almost $10.6 billion, 20 percent more than analysts estimated, and shook up management in the U.S.

Subprime Time

The same day, New Century Financial Corp., the Irvine, California-based rival to HSBC in subprime mortgages, said the market has deteriorated so much that it expects to report a quarterly loss for the first time since 2001.

``The best time to get in is when things are horrible,'' said Anthony Sanders, former director of mortgage-bond research at Deutsche Bank, who now is a finance professor at Ohio State University in Columbus. ``If you can get in at a discount and clean up the underwriting, that could be a big moneymaker when the housing market comes back.''

O'Neal, 55, agreed to buy First Franklin from Cleveland- based National City Corp. in September. Since then, home loans to borrowers with erratic credit records or burgeoning debt burdens have defaulted at a faster rate than during the U.S. recession in 2001, according to Arlington, Virginia-based Friedman Billings Ramsey Group Inc.

`Implode-O-Meter'

So many mortgage lenders have failed in the past two months that a blogger in Georgia set up a Web site to track them and called it the ``Implode-o-Meter.'' His tally, illustrated with a mushroom cloud, stood at 20 as of Feb. 9.

``We still have way too much capacity,'' said David Olson, president of Wholesale Access Mortgage Research & Consulting in Columbia, Maryland, and the former director of market research at Freddie Mac, the second-biggest financier of U.S. mortgages. ``That means a lot more firms have to go out of business.''

O'Neal's ambitions to take on Bear Stearns in mortgage bond underwriting and trading date back to at least 2002. That's when Merrill increased hiring in its mortgage department, said spokesman Bill Halldin. In May 2004, Merrill bought Wilshire Credit Corp., which handles billing and collections on subprime loans. In a speech in November 2005, O'Neal named ``mortgage finance and trading'' among his top priorities.

Merrill, which made more than three times as much money as Bear Stearns last year, took a stake in Ownit Mortgage Solutions Inc. in 2005 and bought many of the company's loans to securitize. Last year, Merrill began extending a $1.7 billion credit line to Middletown, Connecticut-based Mortgage Lenders Network USA, which in a decade had mushroomed from a seven-person firm to the nation's 15th-largest provider of subprime mortgages.

Eroding Standards

At the time, home prices across the U.S. were surging as the growth in adjustable-rate, interest-only and so-called jumbo mortgages, and some of the lowest borrowing costs in 40 years, fueled buying. Lenders provided $640 billion in subprime mortgages last year, an increase of almost fivefold from 2000, according to Inside B&C Lending, an industry publication.

With more than 8,500 financial institutions competing for mortgages, many began extending them to borrowers who might not have qualified previously.

``Too many firms got involved in making loans probably motivated in part by fees,'' Federal Reserve Bank of St. Louis President William Poole told reporters after a speech last week. ``They thought they could lay off the credit risk by securitizing and selling these off in the market.''

Merrill's Claims

In 2003, the year U.S. lenders made a record $4 trillion in new home loans, the industry had 446,500 real-estate loan officers and mortgage brokers, according to data compiled by the U.S. Labor Department. By the end of 2006, the number of loan officers and brokers had risen to 501,000 as the volume of new mortgages fell to $2.5 trillion.

The resulting increase in delinquencies has forced some lenders who sold mortgages under warranty to buy them back at a loss.

Ownit, based in Agoura Hills, California, filed for bankruptcy in December because it couldn't meet those repurchase obligations, and Merrill wrote down its $100 million investment in the fourth quarter. Merrill also has $93 million in unsecured claims, according to Ownit's bankruptcy filing. Last week, Mortgage Lenders Network sought protection from creditors and said in court documents that it owes Merrill $36.5 million.

`Long-Term Investment'

By acquiring First Franklin and doing the lending itself instead of buying loans from other companies, Merrill can ensure that the mortgages it packages into bonds are sound. The firm also stands to gain market share as smaller rivals fold.

``Certainly, we recognized that there was the potential for volatility in the market in the short term,'' Merrill Chief Financial Officer Jeff Edwards said in a Jan. 18 interview. ``We think this is a very important long-term investment for us.'' Merrill declined to make other executives available for comment.

ACC Capital Holdings, the parent of Ameriquest Mortgage Co., announced plans in May to close all 229 of its retail branches and cut about 3,800 jobs. H&R Block Inc., the largest U.S. tax preparer, put its subprime mortgage unit up for sale in November and Sebring Capital Partners LP closed it doors in December.

Countrywide, the biggest U.S. mortgage lender and No. 1 underwriter of bonds backed by subprime or home-equity loans, last month reported its biggest earnings drop in seven quarters. The company said profit may decline this year because the housing slump is leading to more foreclosures and competition.

Goldman's Subprime View

``That's the one area across all businesses in all firms that is actually in a bit of trouble now,'' David Viniar, chief financial officer of New York-based Goldman Sachs Group Inc., the world's largest securities firm, said on a Feb. 8 conference call with investors. ``My view is that that market's going to get worse before it gets better.''

HSBC's troubles stem from its $15.5 billion purchase in 2003 of Household International Inc., then one of the largest U.S. lenders to consumers with poor credit. Beguiled by the high interest rates on subprime loans, HSBC erred by keeping many mortgages on its books instead of selling them to investors. It also bought up the second-lien loans homebuyers use to gain additional leverage.

Bear Stearns, the fifth-largest U.S. securities firm, reduced its purchases of subprime loans by half last year because of concerns over the decline in credit quality, President Warren Spector said on a conference call Feb. 9.

Selling Power

That's not to say Bear Stearns is backing away. The company formed its own mortgage lender in April 2005 and since has increased staffing to about 600 employees from 50. Last week, it completed the $26 million purchase of Encore Credit Corp., the subprime home-lending unit of Irvine, California-based ECC Capital Corp.

Being a force in mortgage bonds confers an ``intangible value'' on a securities firm by attracting investors to the other products it offers, said Randy Robertson, a managing director at Wachovia Corp.'s securities unit. Investment banks can generate additional fees by repackaging the bonds into other securities, such as collateralized debt obligations.

New York-based Lehman, Wall Street's fourth-largest firm, entered the subprime business in 2000 when it invested at least $6 million for a stake in BNC Mortgage. Lehman then spent $219 million in 2003 and 2004 to buy five home lenders, hiring at least 3,300 employees.

Keeping Pace

Deutsche Bank, the world's third-biggest bond trader, kicked off the latest round of subprime consolidation in May by agreeing to buy Chapel Funding LLC. Morgan Stanley, the No. 2 securities firm after Goldman, acquired Saxon Capital Inc. for $706 million in December. Frankfurt-based Deutsche Bank also purchased MortgageIT Holdings Inc., a lender to prime and near-prime customers, for $430 million last month.

Now Barclays, the U.K.'s third-biggest bank, is buying Regions Financial Corp.'s EquiFirst Corp. for $225 million, in part because the London-based bank can no longer count on buying subprime loans from First Franklin and other lenders controlled by its Wall Street rivals.

``Merrill Lynch buys First Franklin and a lot of the flow that would have gone to all the other firms goes away,'' said Michael Wade, head of U.S. asset securitization business for Barclays in New York. ``This business is here to stay. There's a need for the product.''

Declining Margins

Morgan Stanley bought Saxon mainly to gain a foothold in mortgage billing and collections, a business that's ``countercyclical'' because revenue holds steady when refinancing rates decline, said Mark Lake, a spokesman for the New York-based firm. Saxon's $3 billion a year in home loans compares with more than $28 billion for First Franklin in 2006, according to Inside Mortgage Finance. Mortgage-servicing firms also collect fees from overseeing foreclosures.

Viniar said Goldman has no plans to make a large acquisition to increase its share of the subprime market.

For now, the business is less lucrative.

The average pretax profit margin from making and selling a subprime mortgage was 0.25 percent in the first half of 2006 and probably dropped in the last six months of the year, said Jim Cameron, an Atlanta-based partner at Stratmor Group, an industry consultant that runs profitability studies with the Mortgage Bankers Association. Three years ago, the margin was 1.5 percent.

``There's no secret sauce in this business,'' Countrywide's Mozilo said. ``It's a matter of how efficient you are in the securitization process as well as how efficient you are in the origination process.''

To contact the reporters on this story: Bradley Keoun in New York at bkeoun@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net.

Last Updated: February 12, 2007 00:16 EST