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Nonprime and Subprime News | Subprime Statistics
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1998 Bond Crisis; Subprime Lending Before and After

Fog Cutter report chronicles chrisis

August 19, 2004

By COCO SALAZAR


photo of Coco Salazar

The case of a CEO who will keep his job and $2 million salary while serving an 18-month prison sentence sheds more light on the bond crisis of 1998 and the extreme effects it had on the subprime mortgage market.

In the late eighties, companies such as the now defunct Wilshire Credit Corp. jumped into the market and started a new wave of business by acquiring and servicing pools of subprime and defaulted loans.

In the nineties, demand for subprime products skyrocketed and lenders began taking bigger risks with credit as more companies began securitizing nonprime portfolios and drew in many buyers for high-risk bonds backed by securitized subprime mortgages.

The Wilshire business, founded by Andrew Wiederhorn, purchased two banks and grew to have $300 million in assets under management by 1995, and over $3 billion just three years later in 1998, according to a statement issued by the board of directors at Fog Cutter Capital Group Inc., an Oregon-based investment management firm Wiederhorn later became part of.

IMC Mortgage Co. also experienced high growth in the 90s. The subprime lender's loan volume grew to $6.2 billion in 1998, which was about 5% above its 1997 total, but way above the $1.8 billion in 1996, according to an online article of the Wall Street Journal.

However, in late 1998, an international monetary crisis resulted when the Russians defaulted on their bonds and Asian countries suddenly saw their economies falter. Investor confidence grew shaky on high-risk bonds, including nonprime mortgage securitizations, and created a "flight to credit quality." Investors opted for U.S. Treasury securities, and the asset-backed securities market tumbled.

Many companies could not sell their nonprime loans, and with low interest rates and flat yield curve, the subprime securities market faced huge write-downs and liquidity problems as it was hit by a wave of mortgage prepayments and refinancings, which lowered the book value of their securitized loans and eventually caused their stock prices to plummet.

Use of gain-on-sale accounting aided companies' devaluation of assets. Under the gain-on-sale method, the projection of how much a company estimates it expects to make from a portfolio of loans at the time of securitizing it, is accounted for upfront. If the loan defaults or prepayments exceed profit expectations, charges are accounted for in later periods.

MortgageDaily.com publisher Sam Garcia, who co-owned a subprime wholesaler in the late 90s, described the securities market the time as "very aggressive." The profit margin was about 10% on loan pools he would sell to investment firms, much lower than the average 4% profit margin these days, he said.

For many, the wave of prepayments ignited by the bond crisis overtly exceeded profit assumptions. Strapped for cash, some subprime players filed for Chapter 11 bankruptcy protection. Investors reportedly lost billions of dollars in investments and nervously speculated who would come tumbling down next.

IMC Mortgage, which structured its accounting on the gain on sale method, ended up in a cash crisis when its earnings declined due to plummeted value in its interest-only portfolio and residuals from its securitized loans, according to the Wall Street Journal. While the company's 1998 loan volume was much higher than previous periods, that year, it reportedly posted a loss of $100.5 million, compared to net income of $47.9 million in 1997.

In efforts to avoid bankruptcy, now defunct IMC Mortgage came to the point of asking shareholders to approve a plan to issue 491.6 million shares to Greenwich Street Capital and four of its affiliates. The transaction would give Greenwich a 93.5% stake, while leaving shareholders with a 6.5% share, the Journal reported. Even with the restructuring, IMC acknowledged it could be delisted from the Nasdaq as it saw a slim chance of its stock trading above the requirement of $1 for 10 consecutive days.

As for the Wilshire line of businesses, founder Wiederhorn borrowed much of the money used to acquire loan pools. In 1995, he entered into a Master Loan Agreement with Capital Consultants Inc., which committed to lend Wilshire about $150 million, according to Fog Cutter. Interest in Wilshire specified loan pools and the servicing fees secured the loans.

The Wilshire businesses had grown considerably, but shortly after the international woes occurred, Wilshire's "secured lenders panicked and devalued the assets pledged to secure its borrowings, made margin calls that stripped it of cash, liquidated bonds and loan pools at fire-sale prices, and caused [Wilshire's] share price to drop from $25 to less than $5," Fog Cutter said.

Wilshire turned to Capital Consultants for a loan and for the release of a cash reserve it held, according to Fog Cutter. After agreeing to both transactions, Capital Consultants owner Jeffrey Grayson, who was also struggling to stay afloat, demanded the return of personal guaranties he had given Wilshire as part of an agreement for acquiring two of its defaulted loans. Wilshire's in-house counsel reportedly notified Wiederhorn and other senior officers of Grayson's demand, and "concluded, as a legal matter, that releasing the guaranties was permissible and, as a business matter, that Wilshire had no choice but to acquiesce to the return of the guaranties if it wanted the additional money to pay its lenders."

Capital Consultants collapsed in 2000, resulting in a loss of hundreds of millions of dollars in union members' pension funds. Grayson attempted to cover the losses through a complicated Ponzi Scheme that led to a a four-year investigation and seizure of the company by the federal government. "Because of the large amount of money [Capital Consultants] had lent to Wilshire, Mr. Wiederhorn naturally became one of the targets of that investigation," Fog Cutter said.

Wiederhorn pleaded guilty June 3 to paying an illegal gratuity to Grayson and filing a false tax return. He was sentenced to 18 months in prison, paid $2 million in restitution to the Receiver of Capital Consultants, and agreed to pay a $25,000 fine, Fog Cutter reported.

Wiederhorn reportedly violated a federal law relating to pension funds when he agreed to return the guaranties to Grayson in exchange for the release of the cash reserves. The statute requires no proof that a person intended to violate the law -- "in other words, a person could violate the law even if, as was the case here, he had taken all reasonable steps to ensure his conduct was legal," Fogg Cutter said.

"I think I continue to be frustrated that the government chose to prosecute a no-intent violation," Wiederhorn reportedly told the Portland Tribune. "There was no criminal intent. I didn't lie to anyone about anything. I cooperated fully in the investigation. I passed polygraph tests. I told the truth to everyone about everything."

Lance Caldwell, assistant U.S. attorney and lead prosecutor in the Wiederhorn/Capital Consultant cases, reportedly told the Tribune, "Wiederhorn has pleaded guilty to two felony crimes, and is about to go to jail for 18 months," he said. "He admitted he gave financial benefits to Grayson, designed to motivate Grayson to cause CCI to give him additional money. He also admitted filing a false tax return - a specific-intent crime designed to deceive the IRS."

But unlike most who go to prison, Wiederhorn does not have to worry about finding a job when he gets out. Fog Cutter, to whom Wiederhorn served as the sole CEO and Chairman of the Board of Directors, agreed to give him a paid leave of absence of $2 million and to keep him as CEO.

Reasons Fog Cutter cited for its decision, included that the felonies Wiederhorn pled guilty to were not related to Fog Cutter, were performed under legal and expert advise, and did not involve accounting fraud or other corporate financial malfeasance. The investment company also said Wiederhorn was crucial to its business because of his skills, plus, he had also threatened legal action if he was terminated because of his incarceration.

Despite the turmoil subprime players experienced, there is a positive side to the 1990s catastrophe. "What you're seeing now is the crash really brought a lot of discipline into the industry, and good business plans are required to be successful," said Jeffrey Zeltzer, executive director of NHEMA, or the National Home Equity Mortgage Association.

Back in that time, the use of underwriting and FICO scores was not as prevalent, "it was still when work was done a lot by hand, margins were much larger in those days than they are today" -- while the difference in between prime loans and nonprime loans may have been about 4%, but are currently about 1% to 1.5%, Zeltzer said. Since the 90s, "underwriting criteria has tightened up, and technology and I think maturity has allowed companies to better analyze the risks."

In line with Zeltzer's comments, were those made by Richard DeMong, Ph.D., CFA, Virginia Bankers Professor of Bank Management, in a recent testimony before the U.S. House of Representatives.

"When I first researched the nonprime mortgage market in 1998, there wasn’t a precise definition for the characteristics of a nonprime borrower in the literature," DeMong said. "Often, lenders were using slightly different standards. Today, there is a very active mortgage-backed securities market for nonprime loans, which has been enabled by greater standardization ... It is estimated that two-thirds of nonprime mortgage loans are now securitized in the secondary market."

Zeltzer pointed out that even though "everybody called them the hay days of subprime lending," loan volume was in the range of $160 billion to $180 billion in 1997 and 1998, while in 2003, it was about $400 billion.

The subprime sector shows no signs of slowing down, according to Zeltzer. While the subprime market makes up about 10% of the total mortgage market now, "I think the potential, based on today's market realities, we could grow three times. Look at the nation, the nation's changing, more immigrants, more access to credit for minorities and single parents in a household, more people are getting opportunities."


Coco Salazar is an assistant editor and staff writer for MortgageDaily.com.

e-mail: [email protected]



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