125% Mortgages: Asking For Trouble? FINANCIAL ENGINEERING
By Kim Clark

(FORTUNE Magazine) – Daniel T. Phillips makes a pretty unlikely poster boy for the consumer-lending business. Phillips' first two startups flopped. And the third, Dallas-based FirstPlus Financial Group, is in the seemingly reckless business of making second mortgages for up to 125% of a home's value--a practice that Phillips pioneered. The entire high-loan-to-value industry is now under investigation in Washington and has been criticized by the nation's top banking regulator. (After all, plenty of signs--record bankruptcies, for example--suggest that lenders and borrowers may be on a self-destructive debt binge.) Then there's the fact that FirstPlus stock is under attack by shorts.

But Phillips has one thing to recommend him: His high-loan-to-value mortgages are one of the newest, sexiest, and most widely imitated products in consumer lending. As crazy as it sounds, a loan secured by at least the threat of foreclosure is arguably better than, say, an unsecured credit-card loan. In fact, compared with what's out there, Phillips' 125% second mortgages have so far proved to be safer and more lucrative, transforming FirstPlus from a tiny money loser in 1993 into the largest, most profitable lender in a $7 billion market. In 1997 the company's net earnings quintupled, to $139 million, and the stock rose 27%, pushing its market capitalization over $1 billion. FirstPlus is getting 10,000 calls a day from folks drawn in by quarterback Dan Marino's sales pitch: "You don't need equity, just a phone." And that demand is in turn luring big-foot lenders like Advanta, the Money Store, and GMAC into the high-loan-to-value market. According to Peter Rubinstein, head of credit research at Paine Webber, that market is likely to double to $15 billion this year and within a few more could skim the cream off the $500 billion credit-card industry: "The growth curve is exponential."

Dig into the business, and the reasons for the boom become obvious. The loans cost less than credit cards, offer longer paybacks, and even permit tax deductions on interest for amounts up to the value of the home. (FirstPlus customers, on average, use the loans to pay off more than $20,000 in debts and reduce monthly bills by more than $300.) And investors like the business because defaults are rarer on second mortgages than on unsecured credit-card loans, creating higher-than-average profit margins. FirstPlus borrows at 5.6%, spends less than 1% to service its loans, and charges almost 14%, producing a spread about two points wider than most credit-card companies'.

The dangers, though, are just as clear. Prudent Bear fund manager David Tice says FirstPlus is his short pick of the year because fierce competition among lenders will lower margins and loosen credit standards. He's got a point: FirstPlus usually doesn't bother with appraisals anymore--it mostly takes the borrower's word as to a home's value. And competing lenders are offering 135%, 150%, even 200% second mortgages. Comptroller of the Currency Eugene Ludwig, the banking regulator, warns against the loans because a recession could lead to huge losses for lenders and devastating evictions for borrowers. Sen. Lauch Faircloth (R-N.C.) has asked the General Accounting Office to investigate the industry and plans to hold hearings on it this spring.

Phillips, a high school dropout who joined the Marines to straighten up and shipped to Vietnam, is no boy scout. He lost his first two businesses to aggressive expansion and overeager lending. At Sacramento-based LinCo, for example, Phillips bought up a bizarre mix of investments--including health-club-membership contracts and receivables of a gay condo time-share--promising he'd take the company public or sell it to a Swiss bank. "He lied," says James Zarley, who lost $450,000 in LinCo's 1992 bankruptcy.

Phillips denies he lied but concedes he grew the business faster than he could attract capital. "That was the biggest learning experience of my life," he says.

Plenty of smart money is betting he learned his lesson well, including key FirstPlus investors Putnam and GMAC. Phillips has recruited respected executives such as the Money Store's ad chief and Residential Funding Corp.'s risk guru. And in an industry plagued by overoptimism, he has adopted "shockingly conservative accounting and always overdelivers" on his promises, says Graham Tanaka, who has made FirstPlus the biggest holding in his Davis Growth and Opportunity fund.

Phillips says he would welcome a recession, if only to prove that his newfound conservatism has prepared him for a doubling of the current default rate of 2.5% a year. At the very worst, he says, "we won't blow up any worse than a consumer lender." He may be right. In a recession FirstPlus probably won't do any worse than credit-card companies--and no one's launching a Senate investigation of them.

--Kim Clark