Look Before Leaping

Originally published in the January/February 2012 issue

It’s fairly well known that banks are sitting on enormous piles of residential mortgage assets. But what you see is not necessarily what you get. Absent holding a gun to the heads of the largest banks in the US, there is no real incentive on their part to even begin to liquidate the many hundreds of billions of distressed residential first and second lien assets that currently reside on their books. This is the dilemma that faces hedge funds investing in distressed loans. Since the fourth quarter of 2007 – and every fourth quarter since – hedge funds andother investors have expected that the banks would begin to sell into the year end. More than four years after the housing crisis began, only the smallest fractions of those distressed loans have seen the light of day in the market. For starters, the term ‘distressed mortgage’ means different things to different people.

For the purpose of this article (and many bank portfolio managers will privately agree), a distressed loan can actually be current. In fact, a distressed loan may not have ever had a payment missed. A loan should be considered distressed when its liquidation value is less than the unpaid principal balance of the note – and without taking into account lost income and extended foreclosure timelines. A 95% loan to value, spotty pay loan, is no more or less distressed than a perfect pay loan with a 150% loan to value (LTV) ratio.

The market price difference between a 95% LTV loan that is delinquent, and a severely underwater loan that is current, is negligible at best. However, most financial institutions carry these loans at prices 10 to 40 points higher than where they would trade in the open market. The biggest – and perhaps the only – reason distressed ‘current’ loans have not moved off the balance sheets of the largest banks is the huge loss that institutions would incur. In fact, most would conclude that those loan losses are simply being pushed out into the future.

A robust market

For more than two decades, there existed a robust capital market for distressed assets. During that time, temporary market liquidity setbacks were followed by periods of aggressive loan acquisitions (typically culminating in a wave of distressed loan securitizations) that afforded those banks the opportunity to sell in scale. Things now however, are quite different. High delinquency rates and continued home price declines will keep downward pressure on distressed loan prices. Moreover, homeowners are beginning to realize that increased regulatory scrutiny of debt collection practices can work to their advantage.

Foreclosure timelines as long as three years or more in some states have incentivized many homeowners to launch their own personal, financial, self-stimulus package by sporadically suspending mortgage payments – or worse, stop paying altogether. Furthermore, government-mandated programmes like HAMP, HARP, and FHA’s short refi programme – while well-intentioned – still leave a bit to be desired.
They rely too heavily on outdated servicer technology, undertrained staffing, and a misalignment of incentives.

Most programmes also appear to pit the homeowner against the investor. The biggest problem, however with virtually all loss mitigation strategies, is that they do not address the borrower’s negative equity. A solution designed to lower a homeowner’s monthly payment when their LTV exceeds 135% is merely delaying many of the inevitable strategic defaults. While it’s reasonable to assume that a payment reduction will help more than a handful of underwater borrowers, history suggests this relief will only be temporary.

All this – and so much more – has led to what will likely be a very long drought in distressed asset sales to hedge funds and other investors. The third and fourth quarter of 2010 saw a number of distressed loan purchases by some unsophisticated buyers fuelled by – among other things – a misleading but temporary increase in real estate prices caused by the home-buyer tax credit that expired earlier that year. Since that time, a continued and sustained decline in home prices has kept both buyer and seller at bay. To be clear, there have been sporadic bank portfolio loan sales over the past year to some hedge fund investors. To be even more clear, those loans pools are a far cry from what were once considered ‘traditional’ distressed loan pools. Some would classify these loans as future real estate owned or REO.

Portfolio evaluation and risk management
When bidding on loanpools, sophisticated distressed hedge fund investors have already factored in much longer foreclosure timelines and contentious modification dialogue with homeowners. Conversely, less sophisticated buyers do not completely account for these scenarios when evaluating these pools. Additionally, they still don’t fully understand the quiet changes underway in servicing methodologies, regulatory oversight, consumer protection, and most importantly, the homeowners’ will to fight.

Most buyers have begun to realize that future loan portfolios that come to market will become increasingly more difficult to cure. It’s also common knowledge that some of the pools that banks have offered for sale in the last year have been picked-over, modified (sometimes twice or more), or deemed unrecoverable with borrowers classified as professional evaders. In fact, some loans had been kicked – sometimes multiple times – from prior pool offerings, and may not have even been originated by that lender, but rather purchased earlier by their own broker-dealer trying to hide those loans within their bank-originated sales.

If the larger banks have gotten smarter about anything, it’s about what it is they keep on their books and mark at lofty prices, and what it is they choose to package and sell. The phrase ‘caveat emptor’ has never been more relevant than it is now. Not simply because the loan markets are treacherous, but because the sellers – who now need to show senior management they can achieve liquidity whenever they need it – attempt to stack the deck in their favour by selling loans that have little to no chance of performing.

Incentives to increase portfolio value
Traditional loss mitigation and recovery strategies that worked well only a few years ago, simply are not effective on today’s borrowers. There is, however, a new type of incentive-based solution being used both by banks that elect to keep these troubled assets and hedge funds looking to buy those same assets.

This new loss prevention programme and platform launched in 2010 called the Responsible Homeowner Reward has succeeded in using behavioral economics and incentive theory to stem the rising tide of delinquencies, default and foreclosures. The RH Reward employs a simple ‘alignment of interest’ premise to bring both loan owner and homeowner to the table. When both are willing to give a little, they will each gain a lot.

The main purpose of the programme is to keep current loans current, until such time that the loans can be paid off, refinanced, modified, or sold. The loan owners benefit a great deal, but the homeowners benefit as well. This strategy has proven successful with many consumer products for more than 30 years

Since early 2010, RH Reward programmes have lowered delinquency rates on 1st and 2nd lien pools by more than 50% versus respective control groups and have achieved re-default rates of less than 5%. The platform is private labeled, turn-key, and has not increased the infrastructure burden on the loan owner or the servicer. Whether the fund owns, or hires a third party servicer, the RH Reward programme can work seamlessly to ensure delinquencies and losses remain low.

Frank T. Pallotta is a Managing Partner of Loan Value Group LLC. Its incentive-based solutions allow mortgage owners and servicers to positively influence consumer behavior by rewarding timely mortgage payments.