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.
As of late 2011, residential NPLs were trading in the range of 50 to 65 percent of the current market value of the underlying property. These prices are down 5 to 7 percent from their early 2011 highs.
NPLs in states with long judicial foreclosure processes (such as Florida, New Jersey, New York, Illinois), trade at the bottom of that range (or even lower, depending upon pool composition), because longer foreclosure times reduce the return on investment for certain investment strategies. States with non-judicial, and therefore relatively shorter, foreclosure processes (such as Texas and California), trade toward the top of that range (or even higher, depending upon pool composition).
Knowledgeable market participants believe that the attorneys general lawsuit against large national mortgage lenders and bank earnings that are not large enough to adequately offset losses on sales of loans explain the decrease in the volume of NPLs sold in 2011 versus 2010. Another major reason for reduced volumes of sales is that NPL prices have declined as underlying real estate prices have declined. As real estate prices stabilize, or eventually even begin rising slightly, prices of NPLs will rise and even more sellers will come into the marketplace.
Distressed Loan Investment Strategies
There are two general types of strategies used by NPL buyers. Short-dated strategies typically have a time frame of 18 to 30 months and proceed through the following steps: Modify loans if possible. Refinance loans if possible (acquired loan is paid in full). Complete a short sale or pay cash for keys if possible. Foreclose on the rest. Sell the foreclosed property. Sell the modified loans.
These strategies work best in nonjudicial states, and are being used by some hedge funds and private equity funds. Because of the short duration of the investment, there is often insufficient time to repair borrower credit or perform other financial counseling and supportive services that would allow more people to qualify for modifications.
Long-dated strategies have a typical time frame of 36 to 72 months. They usually look like this: Modify loans if possible, remodify if necessary. Provide counseling and credit repair to increase the percentage of loans that qualify for modification, and then modify those as well. Refinance loans if possible (acquired loan paid in full). Complete a short sale or pay cash for keys if possible. Foreclose on the rest. Sell or rent the foreclosed property. Season the modified loans, sell them as reperformers. Sell the rented properties.
Because these strategies operate over a longer time horizon, they can be used in both judicial and nonjudicial states. In a long-dated strategy, more options are open to the patient investor to maximize returns and more people are kept in their homes.
However, there are relatively few for-profit investors putting long-term, patient money in the NPL space because many investors are loath to tie up their funds for extended periods of time due to global economic uncertainties. Some nonprofit investors, due to their interest in keeping more families in their homes, are exploring long-dated strategies (see page 12).
Finding immediate take-out funding for reperforming modifications has been difficult. American Mortgage Capital Group has recently seen reperforming, modified mortgages sell at levels that would yield the buyer a high single-digit return if all the reperformers continued to reperform. The yield to the buyer would be a very low single-digit or possibly a slightly negative return if every loan in the pool defaulted. Realistically, therefore, returns to investors in reperforming mortgages are likely to be in the mid single digits. That return is insufficient to attract large volumes of for-profit capital.
However, if reperforming mortgages are “seasoned” (i.e., held for one or two years after they begin reperforming), their risk is considered to be much lower and they can be resold for a potential profit — another advantage of a long-dated strategy.
Opportunities for Partnership
For nonprofit investors that are able to raise long-dated, patient money to enter the NPL space, there could be myriad opportunities to partner with for-profit investors who may, for example, wish to resell portions of their pools that are from judicial states or those that could benefit from time to repair credit.
For-profit partners could also offer specific forms of expertise. The pricing of mortgage loans, acquisition due diligence, legal compliance pertaining to mortgage sales, and the servicing of mortgage loans all require specialized knowledge and analytical abilities. Organizations seeking to enter the distressed loan market that do not have those abilities in-house would be wise to partner, or enter into fee-for-services agreements, with those who do.