Feb 19 (IFR) - Delinquent and defaulting mortgage loans to struggling US borrowers have become big business on Wall Street, as investors scoop up bonds backed by non-performing loans (NPLs).
With millions of borrowers still under water or facing foreclosure, real estate investment trusts (REITs) and others are snapping up NPLs at a discount, hoping to earn returns from their eventual resolution or liquidation.
And the more value that can be extracted from each loan, the better the returns - which means it is in the interest of investors to work with troubled borrowers to find solutions.
As the cost of funds comes down and yields tighten, loan buyers are finding it more attractive to finance these purchases through securitization, which can sometimes fund between 75% and 85% of the market value of the NPLs, according to structured finance experts.
“Investors are interested in buying NPL securitizations because the senior bond has tremendous credit enhancement and it’s a fairly short-term investment providing more yield,” said Eric Burner, a partner at law firm Hunton & Williams.
“In this interest rate environment, that’s appealing.”
Moreover, the deals delever quickly, and issuers can call the deal after about a year, which is an attractive feature for investors worried about so-called tail risk, or the possibility that an external shock can suddenly cause losses in a portfolio.
From the issuer’s point of view, “securitization is a good way to lever up if you’re a buyer of these assets”, and is an efficient exit strategy, said James Raezer, the head of RMBS at Royal Bank of Scotland.
“There are potentially good returns and you can redeploy the capital.”
Last week, Wells Fargo led a US$260m residential mortgage NPL bond with participation from California-based broker-dealer Carrington Investment Services, which was also the servicer. The distressed loans were bought from several different sellers, including CitiMortgage, Bank of America, and BankUnited NA. The aggregate unpaid balance of the pool was more than US$700m, according to a term sheet.
The deal had a thick 63% layer of credit enhancement and a short maturity of just 1.5 years. The unrated transaction, Stanwich Mortgage Loan Company 2013-NPL1, was priced to yield 3% and was oversubscribed.
Most NPL securitizations include loans where foreclosure, short-sale, or modification are offered as potential resolution options for borrowers but increasingly deals, including the Stanwich transaction, include an option to rent as well.
Some investors frown upon this because the more rentals of REO properties, the less cash coming into the deal and the longer it will take for the bonds to pay down. In other words, the transaction will receive monthly rental payments rather than the proceeds from the sale of the property.
Experts say that players getting into the business of buying and servicing NPLs stand a better chance of maximizing returns when they communicate closely with borrowers to find the best resolution.
“A big part of value creation is through the servicing process,” said Chris Whalen, executive vice-president and managing director at Carrington.
“The key question to the borrower is, Do you have the capacity to get back on track? Do you want to stay in the house?”
Whalen called Carrington a “high-touch” servicer that talks to borrowers in a very constructive way to find strategies to either keep them in their house or talk about creative ways to exit their distressed situation.
“The servicer must be hands-on, and experienced with NPL loans,” said Burner.
“To the extent that you can modify the loan, you want to have a servicer that can work that out and not drag their feet.”
In assessing each deal from a bond investor’s perspective, “so much depends on the expertise and cost of the servicer in concert with the enhancement protections”, said Chris Sullivan, chief investment officer of the United Nations Federal Credit Union.
“In this environment, the note buyers will be forced to weigh these factors and others - including assessments about future home price appreciation and recovery values - against the prospect of receiving a 3% return attached to a presumably relatively short-lived asset.”
In addition to Carrington, firms such as Bayview Financial, Arch Bay Capital, and Residential Mortgage Services Inc, and alternative asset managers such as Oaktree Capital Management, have also been heavily involved in the burgeoning NPL securitization market.
NPL assets typically trade as a percentage of their market value, and for distressed loans this is approximately 50%-60% of aggregate unpaid balances in the current environment, experts say.
Supply of these loans emanates from any financial entity looking to offload NPLs from their books - banks, government-sponsored enterprises, the Department of Housing and Urban Development (HUD), the Federal Deposit Insurance Corporation (FDIC) or the Federal Housing Administration (FHA).
But given the current uncertainty as to whether these entities will continue providing a fresh supply of NPLs, as well as the fact that the booming real estate owned (REO)-to-rental market has attracted new players hungry to buy up distressed loans, prices of NPLs are getting bid up higher than expected - a concern for observers who worry that the market might get too competitive and frothy.
“The REO-rental players have driven NPL prices up, because they view it as a good way to source product,” said RBS’s Raezer. “They are converting them to REOs.”
And because of the high level of credit enhancement and short duration, most issuers don’t bother getting credit ratings.
Raezer said that rating agencies take such a long time to get through the process, and the deals factor down so quickly, that it’s typically not worth it to get a rating.
So far, the transactions have performed well, with no blow-ups. Mostly money managers, insurance companies, and REITs buy NPL bonds, the securitization executive said, although the chief investment office of a large global bank also invested in several recent NPL deals, according to market sources.
However, some participants are worried that if the market heats up too quickly, there could be risk to retail investors who have recently been attracted to the yields that the product offers.
“Historically, the NPL asset class has been an institutional fund - or vulture fund - product,” said a senior executive involved in purchases of NPLs. “The notion that you can address a retail audience is untested.”
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