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Merrill makes mysterious market moves

I’ve had a consistent relationship with Merrill Lynch. I call it about something I’ve heard going on in its mortgage unit and it either fails to return the call or declines to comment. Like I say, it’s a consistent relationship – predictable.

Don’t get me wrong, I’m not hung up on Merrill but it’s an interesting company to write about with regard to mortgage banking in the US.

Why? First, it is a household name. In the old days if you said stock broker, Merrill came to mind. It still manages the largest retail brokerage network in the nation.

But when it comes to mortgage banking I wager that few US citizens except some high net worth individuals realise it is in the residential origination business.

For years, the investment banker quietly operated Merrill Lynch Mortgage of Florida which funded and serviced loans for the brokerage’s rich clients. At one point last decade Merrill even considered leaving the business.

Then the century turned and sub-prime and alternative loan products gathered steam. Merrill realised there was gold in them thar hills.

Merrill has always been an issuer and underwriter of conventional mortgage-backed securities but it also stuck its toe in the sub-prime sector. It bought a servicing company called Wilshire and began financing sub-prime lenders. This is where the story gets interesting.

Merrill and many investment banking firms are warehouse providers to sub-prime non-depositories. By their nature non-depositories borrow money from either Wall Street, a commercial bank or thrift to fund loans that are made to consumers.

The line of credit that is extended to these non-depositories is called a warehouse line and it’s a nice little business if you know what you’re doing. Many firms that extend warehouse lines also securitise loans for their mortgage banking clients.

Not only does Merrill warehouse and securitise loans, sometimes it buys an equity stake in the companies it is financing.

In 2006 Merrill bought a 25% stake in a lender called OwnIt Mortgage of California. It was also providing a large warehouse line of credit to OwnIt. All was well and good until sub-prime delinquencies began snowballing in the summer and reached mammoth proportions late in the year.

In early December OwnIt closed its doors after getting hit with huge buyback requests. What’s a buyback? When a lender funds a loan and sells it to an investor in the secondary market that investor has the right to make the seller repurchase the loan if it goes delinquent in the first 60 days.

In OwnIt’s case most of those buyback requests came from Merrill. But OwnIt decided that instead of repurchasing sour sub-prime loans it would close its doors and file for bankruptcy.

Flash ahead three weeks. Mortgage Lenders Network of New England shuttered its wholesale funding network which accounted for about 90% of its production. It too had been hurt by buyback requests. But unlike OwnIt, MLN had been honouring those requests or working out settlements.

It should be pointed out here that among non-prime funders, MLN ranks 15th nationwide and OwnIt 16th, with market shares of 1.71% and 1.53% respectively.

And who was providing warehouse lines of credit to MLN? Answer – Merrill among others. It is not known which buyers were hounding MLN for buybacks but if Merrill was one of them it will be no surprise.

And here’s the clincher. In early January Merrill bought First Franklin Financial of California, a top ranked sub-prime funder that competes in the same world as MLN and OwnIt. How much did Merrill pay for First Franklin and its affiliate firms? Roughly $1bn.

I’m not a conspiracy theorist but it stands to reason that Merrill’s new sub-prime shop only stands to benefit from the demise of OwnIt and the near-demise of MLN.

What do First Franklin, OwnIt and MLN have in common? They all are massive in wholesale lending which entails the production of residential mortgages through independent loan brokers. Less competition for First Franklin means, well, less competition.

Then again, Merrill reportedly paid $100m for that 25% stake in OwnIt so it makes no sense to shut it down, does it? One lending source tells me some Merrill executives are calling the investment in OwnIt one of the worst transactions it has ever made.

But if it was so bad, why did it pony up $1bn for another sub-prime shop, First Franklin?

Like I said earlier, Merrill isn’t exactly loquacious about its US mortgage strategy so let’s do some math. Merrill invested $100m in OwnIt and is on the hook for $93m in bad loans. Then it paid $1bn for First Franklin. That’s a bet of almost $1.2bn on sub-prime, and that doesn’t include any exposure it might have on MLN.

Will it all pay off for Merrill? Who knows, but if it does I’m sure it won’t tell us about it.

Paul Muolo is executive editor of National Mortgage News

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