When Regulators Knock Twice; Fremont's at It Again!

Saturday, March 24, 2007 | 0

By GRETCHEN MORGENSON

Even dead cats bounce, as the idiom goes, and the stocks of subprime lenders did just that last week. Fremont General, a financial company with a big subprime unit that it is trying to sell, is up 51 percent since it disclosed that it had received a cease-and-desist order from the Federal Deposit Insurance Corporation after the markets closed on March 2. The stock closed on Friday at $8.90.

Bottom-fishers may think that Fremont looks like a bargain. After all, it has a state chartered bank with $8 billion in deposits and a commercial real estate lending arm with $6 billion in loans outstanding at the end of 2006.

"Fremont Investment & Loan has significant balance sheet strength and funding capacity that we believe will enable us to exit the subprime lending business in an orderly and disciplined way," Louis J. Rampino, chief executive of Fremont, said in a statement after the news of the F.D.I.C. action.

The company's management certainly has experience exiting a business at the request of regulators. In 2000, many of the same executives were on hand when Fremont's workers' compensation insurance unit was placed under the supervision of the California Department of Insurance.

Looking back at that debacle shows striking parallels between Fremont's troubles in insurance in the late 1990s and its current subprime woes.

In both cases, Fremont used questionable practices to generate great revenue growth, benefiting executives. Shareholders were left holding the bag. In other words, same plot, different decade.

The insurance part of the story begins in 1995, when California deregulated the workers' compensation insurance market. Fremont Compensation Insurance was poised to prosper. By the turn of the century, it was the nation's sixth-largest workers' compensation insurer.

The California attorney general said in a civil suit filed in October that Fremont executives ramped up the insurance business in 1998 by changing the way the company wrote workers' compensation policies.

The complaint says that the executives breached their fiduciary duties in a scheme that propelled the company's insurance revenues but resulted in enormous losses that contributed directly to its collapse. Defendants in the suit include Mr. Rampino; James A. McIntyre, Fremont's chairman; and Wayne R. Bailey, the company's chief operating officer.

Previously, the company had been willing to cover losses up to $1 million a claim, and struck reinsurance deals to cover additional losses. But its new practice shifted to its reinsurers any responsibilities for losses beginning at $50,000 a claim.

Then, according to the California lawsuit, to generate higher premiums, Fremont significantly increased the risks in the kinds of policies it wrote ' without telling its reinsurers. For example, the company changed 139 so-called high hazard grade, or otherwise risky business classifications relating to potential policy holders, from "prohibited" to "allowed," the lawsuit said. In addition, it said the underwriters were told "to give pricing discounts to insureds whose risk profile indicated that their losses would fall disproportionately on the reinsurers."

The complaint said Mr. Rampino was "the prime mover" behind the shift; he told underwriters at Fremont Indemnity, a subsidiary, that he wanted the company's revenues from premiums to grow to $1 billion by 1999 from $600 million in 1998.

Fremont almost got there. Income before taxes doubled, to $169 million, from 1995 to 1998. For 1999, Fremont generated premiums of $831 million. According to the lawsuit, the reinsurance scheme allowed Fremont executives to exceed the figure used to calculate executive pay "by a hair more than the necessary number." You know what happened then: substantial pay kicked in.

Fremont said that the lawsuit was meritless and that it would fight it. The company did not make the executives available for comment.

The plan began unraveling in 1999 when a Fremont reinsurer recognized problems in the deal and ended it. The insurance company recorded a charge to earnings and a pretax loss for the year.

In the next year, other reinsurers balked, and Fremont's losses began to mount. Its shares plummeted to $1.50 in 2000 from $31 in 1998.

In November 2000, the California Department of Insurance took over supervision of Fremont's insurance company. The company agreed to stop writing insurance policies, stop paying out dividends and refrain from adding executives without permission from the department. Fremont Compensation Insurance was divested in 2002, and the insurance commissioner took over as liquidator of Fremont Indemnity in 2003.

Now fast-forward to the late, great real estate boom. In 2003, even as the insurance mess was unwinding, Fremont's subprime operations were astir. It originated $13.7 billion in residential subprime loans that year, but by 2005 had originated $36 billion. Last year, Fremont vaulted to third place in the subprime lender league.

Naturally, Fremont's shares also recovered. The stock climbed as high as $31 in 2004, but then began a descent as the housing market cooled. It closed in 2006 at $16.21.

On Jan. 4, Mr. McIntyre and Mr. Rampino sold large stakes in the company at that price. Mr. McIntyre sold shares worth $2.3 million and Mr. Rampino sold $2.45 million in stock. The company said they decided to sell in early December. Early March brought the cease-and-desist order from the F.D.I.C., which said it had reason to believe that Fremont had "engaged in unsafe or unsound banking practices and had committed violations of law and/or regulations."

The F.D.I.C. ordered Fremont to stop engaging in "unsatisfactory" lending practices, like providing borrowers with confusing information about loan terms and risks, approving borrowers without documenting their incomes, and using products likely to require frequent refinancing to avoid foreclosure or that include substantial prepayment penalties.

Were the executives aware of the proposed order when they decided to sell their stock? A company spokesman said the executives were not.

The F.D.I.C. would not say how long it worked with Fremont before issuing the order. But Nicholas J. Ketcha Jr., a former F.D.I.C. investigator who is managing director at the consulting firm FinPro, said issuing a cease-and-desist order usually takes one to three months.

The Fremont saga is by no means over. But it certainly seems that the more things change at Fremont, the more they remain the same.

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