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A lender's recipe for downfall

The Baltimore Sun

The home loan program was dubbed South Street.

It turned the idea of credit risk on its head. Consumers just exiting bankruptcy could get a mortgage with few questions. They could have some of the lowest possible credit scores. And they didn't have to submit any pay stubs or tax returns.

Subprime mortgage lender Fieldstone Investment Corp. of Columbia created the loan program during the real-estate gold rush in 2004 as competitors flooded the market.

Such risk-taking would be Fieldstone's undoing.

The company, once ranked among the top 20 subprime lenders in the nation, sank into bankruptcy late last year after loan defaults soared and some borrowers couldn't make even their first few mortgage payments.

In court filings last week, Fieldstone reported $121 million in liabilities, including claims from employees in Maryland and elsewhere, but less than $15 million in assets.

Wall Street titan Morgan Stanley is now its largest creditor and has filed a separate lawsuit.

Lenient loan guidelines became emblematic of what went wrong at Fieldstone - and how far the subprime industry went to snag borrowers and boost volume.

As interest rates rose and competition intensified, Fieldstone pushed to make more loans to offset diminishing returns. And as Wall Street clamored to buy mortgage securities, the company changed the way it did business to capitalize on that gold rush.

Securities and Exchange Commission filings, bankruptcy court records, lawsuits and interviews with former employees detailed Fieldstone's recent downfall.

The company grappled with internal turmoil as well. General counsel Cynthia L. Harkness warned Fieldstone board members in January 2007 about increased production targets that were driving the company to consider more aggressive loan programs. She also questioned whether marketing plans could run afoul of consumer protection laws, according to a whistleblower complaint filed with federal regulators in March.

Harkness alleges she was harassed and fired for questioning the conduct of Fieldstone founder and Chief Executive Officer Michael J. Sonnenfeld.

The company denied allegations by Harkness in regulatory proceedings. Her complaint was dismissed but it is now under appeal.

Sonnenfeld did not return telephone calls seeking comment. Several other executives and board members either couldn't be reached or declined to comment for this article. A lawyer for the company declined to comment on its business practices.

Fieldstone blames upheaval in the credit markets for its shutdown in bankruptcy filings.

Fieldstone's fall was a surprise to some. Industry analysts regarded the company as more conservative than some of its freewheeling competitors, and the company regularly emphasized what it characterized as rigorous quality control mechanisms. In presentations to Wall Street investors in recent years, executives described the company as the "hardest place to deliver a bad loan."

Even the South Street program had a safety valve: Borrowers needed a hefty down payment. If they defaulted, Fieldstone would be more likely to recover its money in a foreclosure.

But as easy credit flowed and subprime loans grew to account for one-fifth of the market, Fieldstone got caught in the industry's race to the bottom despite signs of trouble, according to former employees. And when the industry collapsed, Fieldstone went with it.

"They were trying to keep up with competitors," said Betty Williams, a former assistant vice president of credit administration at Fieldstone. "Everyone wanted to get into the mortgage industry, just like everyone wanted to get into the computer industry five years earlier. Fieldstone started a lot of new programs to keep up."

Housing bubble

Fieldstone went public in 2005 after 10 years in business and in the midst of a housing bubble that resembled the dot-com craze of the late 1990s. Home sales reached an all-time peak that year and housing prices posted the largest-ever gain, when adjusted for inflation.

After losing money for several years while investing in more workers and facilities to establish a nationwide footprint, Fieldstone saw its profit double in 2002 and 2003. It doubled again in the next two years to about $100 million.

Executives had crafted a new business plan under which they no longer sold all the mortgages they originated but kept a portfolio of subprime loans and financed them by issuing mortgage-backed securities secured by the loans. They sold the first batch of securities for $488 million in October 2003. In a year, the company had sold more than $4 billion of the securities.

Sonnenfeld rang the opening bell at the Nasdaq stock market the month after the stock's debut. The digital sign overlooking New York's Times Square displayed the Fieldstone logo.

"It was a neat time. We thought it was just one step in a long-term plan," said Robert G. Partlow, Fieldstone's former chief financial officer, who resigned a few months later because his family didn't want to move from Richmond, Va., where he had been based, he said.

"We didn't think we were going to take over the world. We were trying to do the business the right way, where we balance credit risk and have a good balance sheet."

Still, there were cautionary signs even back then, Partlow acknowledged. The company saw a decrease in its net interest margin - the difference between interest earned on loans and expenses. It also watched its gain on mortgages as a percentage of sales slip from 3.4 percent in 2002, to 3 percent the next, to 2.5 percent in 2004.

The pressure was on to make more loans, the company said in SEC documents. Meanwhile, Wall Street firms were buying mortgages made to borrowers with riskier profiles to keep volume high. Most lenders went along because they thought they were passing off the risk.

The subprime business is typically more profitable than conventional lending. Because the lenders provide loans to people with unstable financial histories, they charge higher interest rates.

The industry helped fuel the biggest jump in homeownership since the post-war boom of the 1950s, providing more lower-income families with increasingly inventive home loans.

At Fieldstone, the loan portfolio consisted almost entirely of adjustable-rate mortgages and most had a temporary "interest only" feature, allowing lower initial monthly payments. In general, a Fieldstone borrower would see the interest rate adjust upward after two years, and even larger payments after five years when principal was added to interest.

More than half of Fieldstone's subprime borrowers were allowed to provide little or no documentation of their income, according to SEC filings. Instead, the company relied on credit scores, property values and how the loan affected the borrower's debt levels. These "stated income" mortgages were originally designed for self-employed borrowers but became more widely used and known as "liar loans."

Fieldstone also made roughly half of its subprime loans in the frothy California market. And the company actively sought borrowers with a history of not paying bills and high debt, using mass marketing campaigns and customized mailers to reach them.

Fieldstone did have quality controls in place. It had a way to detect house flippers and to guard against predatory lending when borrowers refinanced. It gauged the performance of underwriters monthly and cut ties with brokers whose loans went bad, according to regulatory filings.

But the company had a blind spot in its system. It couldn't track mortgages it originated before mid-2003 - or how often the loans defaulted or were paid off early - because it sold all of its loans, according to filings. So executives couldn't really know how well their quality checks would protect them from losses.

Industrywide data on subprime loan performance that Fieldstone executives could review was obscured by a backdrop of home prices that had been rising since the mid-1990s. Higher home prices masked problems because borrowers could sell with enough equity to cover the loan.

And in the heights of the subprime boom, pushing the lending envelope became the norm. Williams, who left Fieldstone in May, said she didn't worry about the lending guidelines at the time because brokers often complained they were too restrictive for them to compete. In retrospect, she said, the company didn't watch its operations or borrowers closely enough.

Steve Morberg, a former West Coast account executive, said the company often lagged behind the market with new products. "We were always told by management: 'We're doing it right. We want to stay in business. We don't want to do those crazy loans,'" he said.

Expecting demand

Even when loan delinquencies began to rise and home appreciation slowed nationwide, Fieldstone executives said they saw opportunity. According to a presentation to investors in Las Vegas in January 2007, executives argued that competitors wouldn't be able to survive and that rising consumer debt would drive demand for subprime loans. They also said they would tighten lending guidelines and add to their sales force.

But at that time, they were getting margin calls from Wall Street lenders. And one of their peers, Harkness, was making waves.

The general counsel had been with the company since 2004 and had weathered her share of corporate upheavals. She was a lawyer at Enron Corp. before it collapsed and, according to one press account, she once questioned Andrew Fastow, the chief financial officer, about his now infamous off-the-book partnerships that landed him in jail for fraud.

Harkness contends that she raised red flags at Fieldstone about Sonnenfeld's behavior. She said, according to her complaint, that she advised him of inappropriate interaction with investors and analysts that could expose him to liability under insider-trading laws. She also said she told him that a proposed award program for brokers could violate a federal consumer protection law.

Then in late 2006, she told the company's outside auditors that she was unsure whether top executives were committed to ethics and legality, in part because she and other members of the legal department were routinely excluded from meetings.

Harkness alleges that she was fired a few weeks later for speaking out. About a week after that, she submitted a report to directors outlining her concerns.

She declined to comment for this article. The Department of Labor, which administers the whistleblower program, dismissed the complaint regarding her termination. It did not weigh in on company practices. The agency's decision was appealed to an administrative law judge, her lawyer Daniel F. Goldstein said.

Fieldstone agreed in February to be bought by Credit-Based Asset Servicing and Securitization LLC. Officials with the New York firm known as C-Bass couldn't be reached to comment.

Then in August, as C-Bass itself received margin calls, Fieldstone was no longer able to access the credit markets and couldn't originate any mortgages. The company laid off most of its workers, which once numbered more than 1,000, and is now operating with a skeleton crew of 25 people.

Morgan Stanley and Lehman Brothers sued Fieldstone to force the company to repurchase bad loans. According to the lawsuits, borrowers failed to make a payment within the first six months and incorrect information on appraisals and borrower qualifications was submitted.

Nonetheless, Fieldstone's bankruptcy lawyer, Joel I. Sher, said the company hasn't ruled out getting back to business once the bankruptcy is resolved. Many industry analysts predict a comeback for subprime mortgages, though with far more restrictions on borrowers as well as lenders.

laura.smitherman@baltsun.com

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