“By failing to prepare, you are preparing to fail” – Ben Franklin
If recent economic times have taught us anything, they have taught us to prepare for any eventuality. Whole loan liquidation may not be something that comes under consideration everyday, but when it does it is best to emulate the Boy Scout and ‘be prepared’. This article outlines best practices for servicing current and delinquent loans. It further recommends maximizing portfolio value by employing a strong workout policy and then outlines the process of selling whole loan portfolios.
A Strong Workout Policy Can Net Results
Portfolio values can be enhanced by restructuring loans to those borrowers who have suffered and overcome temporary financial setbacks and are now willing and able to sustain a repayment plan. If the restructured loan makes sense for both the borrower and the lender, what was once non-performing can become a valid performing loan. It is not realistic for the borrower to request a rate reduction to zero, extend the amortization and maturity date out to 50 years, and reduce the principal balance by 25%. But on the other hand, it may be more prudent and make good business sense for the lender to modify the loan terms if the borrower truly has overcome their hardship and is capable of sustained continued repayment.
Implementing a successful workout process should lower the overall default rate by converting loans from non-performing into performing. The impact a successful workout policy can have on portfolio value is indicated by Figure 1. At an assumed 25% probability of default (POD), the base price of this portfolio is 79.87%. For example, decreasing the probability of default by 25% (to 18.75% POD) can increase portfolio value to 82.11%. On the other hand, if POD increases by 25%, the estimated portfolio value decreases to 78.17%.
Collateral Recovery and Liquidation
Under normal market conditions, the length of time it takes a servicer to convert a non-performing loan to a saleable real estate asset (OREO) affect the portfolio’s value. Unfortunately in today’s uncertain market, many lenders are delaying moving defaulted loans into OREO assets given the difficulty of liquidating the collateral in current depressed housing markets.
The potential impact of speedier (or slower) foreclosure times is illustrated in Figure 2. (Again, the base case assumes POD of 25% and a price of 79.87 %.) If the total time to complete the foreclosure and liquidation decreases by 5 months, the portfolio value increases to 80.70%. Conversely, if this same timeframe increases by 5 months, the value declines to 79.02%.
Commercial loans are commonly structured with balloon maturities. In today’s difficult real estate markets, many commercial borrowers are encountering difficulties refinancing to at the balloon date. This can be caused by a decline in the property’s financial performance or market value. Under these circumstances, the lender can benefit from restructuring if the borrower has the ability to continue monthly debt service. For example, extending the maturity date by 12 to 36 months might provide sufficient time for the borrower to stabilize the collateral or for market conditions to improve. Additionally, it may make sense to alter other terms of the loan, for instance by requiring extra principle payments or the addition of extra collateral.
Restructuring Updates Loan Data
While the objective of restructuring is to convert nonperforming into performing loans, it can have a secondary effect on portfolio value, by generating updated FICO scores, financial statements, tax returns and rent rolls.
Whole Loan Portfolio Sales
The whole loan portfolio sales process comprises many steps. The process flow is summarized in Figure 3 and Figure 4 indicates the typical time line and duration of each step. Each step and its role in the overall process is outlined below.
Set Expectations
Having a clear understanding of the how the transaction will occur is critical. The agreement between the seller and the loan sales advisor sets expectations of the probable transaction terms, the advisor's marketing strategy, and price expectations.
Loan Data Preparation
Well organized loan files will enhance the overall loan sale process and maximize prospective buyers' bids. The more straightforward a buyer's review and less uncertain loan values are, the better the offer price. Critical documents include the promissory note, appraisal, and payment history. Residential loan files should include original and updated FICOs. Commercial real estate documents should include:
• Current annual / quarterly statements
• Credit memos
• Annual credit reviews
• Classification review and tracking
• Past and current rent rolls
• Past and current operating statements
Data Quality and Accuracy is Key
It is important to closely review the data file proved to prospective buyers. In particular, review it for internal conflicts. For example, in Figure 5, lists five loans, two of which - highlighted in red - contain conflicting information. In the first case, the 3.25 million loan, the disclosed debt service coverage ratio (DSCR) is 1.32, but the DSCR check nets a value of 0.71. Faced with uncertainty, a buyer is most likely to choose the lower one. The supplied loan to value (LTV) for the 3.25 million loan is listed at 75% but the calculated LTV is 114%. Here too a buyer is most likely to use the higher.
Marketing
The loan sale advisor prepares customized marketing materials and circulates offering documents to qualified potential buyers. It also manages the loan sale process, answering questions and guiding buyers through the process
Confidentiality Agreements
Prospective buyers must execute confidentiality agreements.
Indicative Bids
Buyers will submit indicative purchase offers (bids) based solely on the loan data file. All final offers are contingent on a complete review of the loan files. The loan sale advisor analyzes indicative bids and recommends which bidders should be invited to perform due diligence and make final competitive bids. Normally, two to four buyers are invited into this group.
Due Diligence
The due diligence process allows the buyers to physically review the loan files and to confirm the data that was supplied. The typical timeline is three to four weeks. The loan sale advisor manages all aspects of the due diligence phase, including planning the review, and monitoring the reviewers. Buyers will disclose their due diligence results to the seller.
Final Bid
The final bid round is conducted after due diligence is completed. Prospective buyers submit non-contingent final bids based on the pre-negotiated asset sale agreement.
Commitment Letter
If a bid is accepted, buyer and seller execute a commitment letter which outlines the terms of the sale.
Closing
Successfully completing a transaction requires more than a transfer of funds. The seller must meet a complex array of operational, data and contractual deliverables. This process requires a dedicated team who specialize in data management, delivery, and processing.
Loan Sale Timing
The time required to complete a loan sale is determined by many factors, particularly the total size of the portfolio.
Simultaneous Selling
Simultaneous sales of numerous sub-portfolios, even those of nonperforming loans, can be accomplished by the auction method or through negotiated sales. The negotiated route offers anonymity but can require more time for marketing.
Optimal Execution Timing
Assuming infinite market capacity, execution times would simply reflect execution times for the various sale processes of clean-up and packaging, marketing, bid taking, buyer due diligence and settlement. Typical timing guidelines are listed in Figure 4.
Market Timing and Buyer Fatigue
However, market capacity is not infinite. Buyers enter and exit at various times. Markets and the capital available at any one time can be exhausted by several large sales. For this reason, sale time for a given portfolio or whole bank sale is dictated not by processing capacity or efficiency, but by market capacity (or “buyer burnout”) as well as the number and size of competing offerings. For this reason, piecemeal selling of large portfolios typically produces better prices than a single sale or auction conducted over a few months.
Note:
• At its peak, the CMBS markets could absorb $230 billion of rated product annually. By contrast, whole loan markets have always been more fragmented and less liquid than securities markets (the exception might be in M&A markets, where whole bank sales can be executed when sufficient franchise value exists).
• Market liquidity is such that sales should be staggered in blocks of $1,500 million (1.5 billion) or less within a commercial product type. It may be possible to sell larger blocks of residential product.
• Assuming such staggering and that sales are executed on average over ten week periods, sellers should anticipate that it could take months (even a year or more) to market large blocks in an orderly sale and achieve orderly sale pricing.
Summing Up
To reiterate, preparation is vital to structuring successful whole loan portfolio sales. Putting the procedures in place to conduct effective workouts, maintain current loan data, decrease foreclosure and liquidation timelines and manage all stages of the loan sale process will avoid confusion and save time and, most importantly, money. MIAC has the tools and know-how to assist you in implementing best practices and to arm yourself against the “what’s and if’s” in your portfolio.
Best Practices Enhance Portfolio Value
By following best practices, lenders can maximize the prices at which they sell whole loans.
Analyzing Repayment Capacity of the Borrower(s)
When restructuring loans, repayment analysis must adhere to the same strong underwriting principals of credit review and underwriting as loan underwriting. The three “Cs”, capacity, character, and collateral are still paramount. Care must be taken to ascertain that the hardship is truly past and the borrower has the ability to sustain the new repayment terms. Use this opportunity to determine and document the current status of the collateral.
Modifications
There are key differences between residential and commercial loan modifications: Residential loan modifications may be driven by policy and regulation. Commercial loans follow accepted industry practice requiring borrower-specific review by qualified individuals trained to identify the best course of action.
HAMP (Home Affordable Modification Program): Intended to provide eligible borrowers who are either in default or those at immediate risk of default with an affordable and sustainable loan repayment terms.
2MP: Second lien modification program designed to work with in conjunction with HAMP
HAFA (Home Affordable Foreclosure Alternatives): Intended to reach borrowers who have failed the HAMP modification process by completing either a short sale or deed-in-lieu. The collection deficiency balance is not pursued against the borrower.
Forbearance is a temporary reduction or suspension of payments which must be immediately followed by an arrangement to cure the delinquency.
Evaluating Guarantors
Many commercial loans have additional support in the form of guarantees. It is as essential to review the guarantors' current financial situation as it is the borrower's. The analysis should determine if the guarantor’s overall financial condition enhances the likelihood of repayment?
Assessing Collateral Values
Current valuations of the collateral are critical to successful loan portfolio sales. The valuation process should include either third party appraisals or broker opinions of value (broker’s price opinion). Additionally, an onsite property inspection should be completed to evaluate the current condition of the property.
Valuation Process
Broker’s Opinion of Value (BPO) are completed by licensed real estate professionals who are active in the market for the property in question. BPOs are less costly than traditional appraisals. In some cases, the realtor may even provide them free of charge. Realtors providing BPOs are the likely sources to liquidate OREO coming out of the loan portfolio.
Third party appraisals are more costly than BPOs. The cost can range from $200 to $600 for residential appraisals to $1,500 to $10,000 (and up) for commercial valuations. All appraisals should be completed on an ‘As-Is’ valuation basis. Avoid “As-Will-Be” or “Subject-To” valuations except in special situations. Even when it is appropriate to obtain a valuation other than “As-Is”, it should only be done in addition to the “As-Is” value. Commercial property valuations should be completed by a certified MAI (Members of the Appraisal Institute) appraiser.
Information generated by onsite property inspections is valuable information for thorough valuation. Such inspections ascertain the current condition of the property and determine best way to secure and protect it in the event the collateral of foreclosure.
Foreclosure
The foreclosure process is completed by one of three main methods.
· Deed-in-Lieu is a voluntary conveyance; it occurs when a borrower voluntarily transfers title and possession of the property to satisfy the mortgage loan debt and avoid foreclosure.
- A short sale releases a lien on a property in exchange for the proceeds of the sale for less than the outstanding amount owed
- Deed of Trust or Judicial Process:
- Foreclosure timing varies from state to state and county to county. Generally speaking, completion of the foreclosure occurs faster in jurisdictions that utilize a Deed of Trus
- The lender’s ability to collect a deficiency balance also varies by state. Collection of a deficiency balance may not per permitted in states that use Deed of Trust. It is important to fully understand the foreclosure and collection laws of each state during your preparation.
Property Maintenance
Ensure that the OREO asset is property secured is a crucial part of the process. This will help prevent theft or vandalism and help reduce your over liability. Remove debris from the property to eliminate the “public” nuisance factor and perform routine cleaning and maintenance.
Having proper insurance coverage on the property is important and should not be overlooked. Review your existing policies to validate that coverage is available on your OREO assets. It is often necessary to purchase separate policies to receive proper coverage.
A tax service must be completed for each asset to ensure that all delinquent property taxes are paid. The tax certificate sale process varies by state and county. A thorough knowledge of this process will ensure that loss of collateral or ownership rights do not occur.
Joseph A. Furlong
Vice President, Capital Markets Group