The news these days is constantly full of stories about the market for foreclosed properties. But how often do you hear about the market for distressed mortgages themselves? A lot less. That’s at least partly because it is private. Trades are rarely publicized. There are no exchanges or reliable services that report prices and volumes. Market participants do business under comprehensive non-disclosure agreements.
But nonetheless these loans are being actively traded. According to knowledgeable participants, about $17.5 billion of residential distressed mortgages (roughly 100,000 loans) were likely sold in 2011. Approximately $26 billion (roughly 149,000 loans) were sold in 2010. Knowing something about how this market works and who is participating in it can be useful for those trying to stabilize neighborhoods with high concentrations of distressed loans — and possibly even open opportunities for partnership.
How Distressed Loan Sales Work
In mortgage capital markets, mortgages that are 30 or more days delinquent, including those that are in foreclosure, are described as “non-performing loans” (NPLs). Approximately 12.6 percent of all residential (one- to four-unit) mortgages are now NPLs, according to the Office of the Comptroller of the Currency and the Mortgage Bankers Association. That’s roughly 6.5 million loans, totaling approximately $1.13 trillion.
NPLs are generally sold in groups or “pools” that can be as small as $1 million in unpaid principal balance (UPB), which would be five to six loans, to as large as $500 million UPB, or 2,500 to 3,000 loans. There have been rumors of NPL trades between very large sellers and very large buyers that involve pools over $1 billion in UPB, but they are unusual. Pools trade based upon pricing of the individual loans in the pool. As a result, individual pool prices can vary substantially based upon their precise composition.
NPL pools are sold subject to acquisition due diligence by the buyer. Due diligence typically includes a review of each borrower’s situation to determine the likelihood of their loan performing again and a review of the original loan documents to see if all consumer disclosures were accurately made to the borrower, whether the loan was legally made, and that the loan documents are enforceable. The current market value of the secured property, its general condition, and its occupancy are also major focuses of pre-acquisition loan due diligence.
After due diligence, the buyer may choose not to buy certain loans or to buy them at a different price. NPL purchase transactions often fall apart because of re-pricing after due diligence. Successful buyers tend to spend a significant amount of time pricing and analyzing pools before their initial bid to minimize this.
Sellers will sometimes create pools tailored to the requirements of certain buyers. Such tailored pools, (“carve-outs”) usually include specific limits on geography, loan size, degree of delinquency, and other factors. Before creating a carve-out for a buyer, the seller must be assured that it will be adequately compensated for doing so. Repeat buyers with well-understood requirements are the most successful in negotiating carve-outs.
Most of the loans sold in the NPL market today come from the large mortgage lenders. Those sellers tend to do large trades (average $300 million UPB). Sometimes investment banks and hedge funds buy loans from large lenders and resell a portion of the loans if they think that they can get a better return by flipping them. Small NPL buyers frequently buy from financial intermediaries that have purchased large pools from large lenders.
However the original sellers acquired the NPLs, they are motivated to sell them by a combination of operational capacity constraints, profit taking (if they are financial intermediaries who create and resell small pools from large pools they have purchased), the need to report fewer non-performing mortgages on their books, and the desire to redeploy the capital tied up in these loans at a higher return elsewhere.