Can This Mortgage Marriage Be Saved?

Buyout group Lone Star wants to wriggle out of its deal to buy troubled lender Accredited Home

With the mortgage industry imploding, the only hope for many lenders is to find someone bigger and more financially secure to buy them out.

Accredited Home Lenders (LEND) thought it had found such a savior in June, when private equity firm Lone Star agreed to buy the mortgage lender for $400 million. The $15.10 per share offer was better than many expected, despite the fact Accredited shares were trading above $50 a year before.

On Monday, Accredited sued Lone Star to force it to complete its purchase. But Lone Star said in a statement it is running away from the deal "in light of the drastic deterioration in the financial and operational condition of the company."

Analysts say Lone Star might have difficulty getting out of the deal based on that criteria. Judging by the language of the agreement, "it appears that Lone Star was making a pretty firm commitment here," says Chris Brendler, an analyst at Stifel Nicolaus (SF).

Should Lone Star might have known what it was getting into? After all, for months investors have known about problems with subprime mortgages — loans to borrowers with poor credit ratings, who are now defaulting on those mortgages at alarming rates. Subprime concerns, along with the overall decline of the housing sector and new loan originations, caused the stocks of Accredited and other mortgage lenders to plunge.

Lone Star might have thought it was getting a bargain. Accredited is "one of the better platforms out there," Brendler says, with better credit quality than most.

But instead of hitting bottom earlier this summer, the mortgage industry had much farther to fall.

Rising anxiety on credit markets destroyed the typical mortgage lender's business model, analysts say. Rather than keeping loans on their books, lenders rely on a secondary market to buy up those mortgages. Those markets provide the cash for lenders to go out and originate more loans.

Now, however, "the secondary market has frozen up," says Morningstar (MORN) analyst Erin Swanson. Scared investors are refusing to buy up riskier mortgages.

That's causing a cash crunch for many lenders, especially those with no other source of cash or capital. Lenders that are part of larger corporations, or that are banks with depositors, have a built-in cushion. But companies like Accredited rely on credit that can be called in at almost any time, Swanson says. A couple weeks ago, American Home Mortgage (AHMIQ) declared bankruptcy for this reason: Its creditors called in debts, and it was simply out of cash.

"The business model is currently broken," says Stifel's Brendler. (Accredited is an investment banking client of Stifel Nicolaus.)

It's not clear how Accredited's legal issues will be settled, and whether the firm will be able to avoid bankruptcy before then. "Accredited remains open for business," the company said in a statement, saying it is communication with its warehouse credit providers. One possibility, depending on what happens in court, is that Lone Star will offer a lower purchase price. Accredited has been trading well below the $15.10 per share price for weeks.

One thing that is clear is that the independent, stand-alone mortgage lender is becoming an endangered species. There have been a number of buyouts and bankruptcy since subprime worries started.

Mortgage lending is "a very volatile business," Brendler says. "There's so many things that can go wrong." In the perfect conditions of the last few years, lenders racked up big profits, but not today.

Many lenders will only survive as part of larger companies, which have the capital to tide them over until good times return and credit markets return to normal. Among the firms that have bought up mortgage lenders or their assets this year: Private equity players Fortress Investment Group FIG, Cerberus Capital Management, Citadel Investment Group, and GE Capital Solutions, part of General Electric (GE).

Swanson says an "industry shakeout" could have some benefits by eliminating some of the "irrational players in the market."

After all, it was heated competition that got the industry in all this trouble, causing lenders to issue mortgages to people who probably couldn't repay them. Many lenders "weren't pricing risk appropriately," Swanson says.

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