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   ARTICLE   |   From Scotsman Guide Residential Edition   |   October 2004

Challenges of Retaining & Servicing “Scratch & Dent” Loans

Return of Capital Is More Important Than Return on Capital

As the current rate environment decelerates the refinancing boom and as more originators enter the world of subprime lending, many bankers are sure to find themselves stuck with a few loans that they are unable to sell to their primary investor base. Some originators, constrained by their liquidity needs, sell such loans immediately, often at a slight discount, depending on the nature of the “scratch” and the severity of the “dent.” Original capital is recouped as quickly as possible in an effort to relend, allowing the lending/earning cycle to continue. Others, perhaps those with larger balance sheets and more free cash flow, have the luxury of deciding whether they are better off keeping their “scratched and dented” loans or selling them in the secondary market.

Scratched and dented loans usually are loans that have fallen out of a sale or have been required to be repurchased. The list of issues is long and can range from something as simple as a missed ratio or guideline to more serious problems (i.e., first-payment defaults, valuation discrepancies or even fraud). An obvious, albeit common problem, is a volatile interest rate environment moving in the wrong direction. Any one of these issues is capable of rearing its ugly head and tainting your loan as scratched and dented.

The decision to balance sheet these loans or sell them can be a complicated one. On the surface, no banker wants to take a loss on a loan that he/she believes should have sold for par or better. Why sell a current loan that fell out of a bulk sale due to a missed FICO score, maybe at a discount, when the last 10 payments have been made on time? Alternatively, what is the rush to sell a nonperforming, 80 percent LTV loan when the foreclosure sale is set for a month from now? The answer to such questions would obviously depend on several factors (i.e., the nature of the setback of the loan, the equity position or loan-to-value, the warehouse line’s leniency for aged/sub and nonperforming loans and the company’s overall cash needs). However, what is often haphazardly overlooked when deciding whether to retain scratched and dented loans is the multitude of servicing challenges that will undoubtedly arise.

A common yet critical servicing mistake is to hold on to scratched and dented loans for too long, hoping that the situation will mysteriously go away on its own. This logic is similar to the argument used by buyers of many failed Internet stocks during the tech bubble in early 2000. A large number of these investors made the decision not to sell, even though the first signs of trouble were loud and clear. They had the chance to get out with only a small loss (or perhaps with less of a profit), but they kept thinking it was going to rebound—if they could just hold on a little longer. The important lesson learned was that the return of capital is far more important than the return on capital. This simple axiom holds true when deciding if you should sell your scratched and dented loans. 

While some scratched and dented loans may be current, they still present a unique set of servicing challenges. Often times the borrower might be prone to significantly higher delinquency rates, necessitating very close monitoring. For instance, you may have found yourself to be the proud owner of a 100 percent LTV-uninsured FHA loan. Even if payments are made on time, there still clearly is a higher level of risk inherent in the situation that demands a very watchful eye and close contact with the borrower. As such, it may be in your best interest to compare the cost of selling such a loan vs. retaining and servicing it for the long term.

For performing loans, the obvious options to compare are: (1) rewriting the loan, (2) keeping the loan or (3) selling the loan. Rewriting the loan necessitates having the available liquidity to hold it for a while, as it might take some time to close the new loan. Additionally, the borrower might be reluctant or even unwilling to reclose the loan, leaving you with one less exit strategy. The decision to keep the loan on your balance sheet and service it is accompanied by additional factors (i.e., the interest expense incurred to carry the loan on your warehouse line, the company’s short-term cash needs, default risk and interest rate risk).

Selling the loan quickly and decisively allows you to recoup the lien share of your principal, leaving you free to originate more loans. Again, the return of capital vs. the return on capital. Let’s review the following hypothetical scenario: You are an originator with a $5 million warehouse line, and you are able to turn the line 2.5 times per month, resulting in a monthly origination volume of about $12.5 million. Assume you have $300,000 in “dented” loans, which implies that you have $750,000 per month ($300,000 x 2.5 turns) that you will not be able to originate, if your cash flow is tight. The front and back end fees on $750,000 might be two points (or a potentially lost income of $15,000). Selling your “dented” loans at 99 percent provides you the opportunity to net $9,000 ($15,000 less the point on the “dented” loans) in income that you otherwise would have not been able to earn.

If servicing scratched and dented performing loans is a bit challenging and requires a specific skill set, then it could not be truer than when it comes to servicing subperforming, reperforming and nonperforming loans. The list of servicing challenges is lengthy (e.g., negotiating preforeclosure short sales, ensuring that your current second lien position does not get foreclosed out by a third-party, delinquent first lien, avoiding tax foreclosure sales and unpaid hazard insurance, preparing PMI claims by identifying and tracking claimable items, executing DILs, drafting loan modifications and written forbearance agreements, monitoring verbal repayment plans, correcting title issues, monitoring foreclosure actions and, most importantly, spending valuable time educating, not alienating, the borrower).  

To be serviced successfully, subperforming and nonperforming scratch and dent loans require an immense amount of dialogue with the borrower—often quite technical and time-consuming conversations—in an effort to help the borrower understand what the options are and the steps he/she needs to follow to avoid foreclosure. For this dialogue to take place, the loan servicing staff must first be knowledgeable about what these options are, and second they must understand when certain options are applicable and when they are not. Trying to modify a 125 percent LTV loan probably does not make sense, given that you’re essentially throwing good money after bad into an unsecured position. And, if you do modify a loan, should you send it out for recording, or will you risk potentially subordinating yourself? Who can and cannot sign the agreement? Such complexities dramatically increase when dealing with first and second liens, divorce situations (e.g., who is on the note vs. who is on the title) and bankruptcy and foreclosure proceedings within the myriad of state and county laws. Again, this is very time-consuming, technical work that demands experience.

How to Sell Your “Scratch & Dent” Loans

Once you have made the decision to sell your scratched and dented loans, planning ahead will prove to be the most critical step, especially for the smaller players hoping to navigate around any potential cash flow troubles. If well-prepared, you will be less likely to get involved with a poorly funded buyer that can’t close the deal in a timely manner or with an unscrupulous broker who misrepresents him/herself as a direct portfolio buyer. Good preparation will result in stronger execution by saving both time and money.

After you have identified a handful of scratch and dent buyers, it is important to get to know them and their individual processes and requirements. This will help you know in advance what information each of them requires so you can accurately bid on your loans, and fund and close the deal quickly. Essentially, you will need to compile the necessary loan data (often called the “tape”) into a format that can be easily distributed and reviewed. Excel spreadsheets work great in this situation.  

The tape should include, at a minimum, the following data: the current unpaid principal balance, the next due date, the interest rate (fixed or adjustable), the margin and index (if adjustable), the lien position, the type of property (single family, condo, two to four family, multifamily, manufactured, mobile home, etc.), the city and state in which the property is located, the origination value or updated broker price opinion (BPO) value, the loan’s insurance (if applicable, private mortgage insurance, FHA or any other guarantor, including the percentage of coverage), the origination or updated FICO score and possibly even a 12-month pay history counter, indicating the number of times the loan was 30, 60 or 90 days past due. 

Once the tape is completed and the necessary data is reviewed for accuracy, e-mail the tape out to your various contacts, making sure that you clearly set a bid deadline (three to five days are enough time). Setting this deadline will help to facilitate timely execution and make your job easier. You should expect to receive indicative bids from your potential buyers, suggesting what the interested buyer is willing to pay, based on what was represented, yet stopping short of providing any type of commitment. In addition, once an indicative bid has been verbally accepted, a bid letter is prepared and signed by both parties. The bid letter identifies the pool of loans to be sold and the indicative price that was quoted.

Typical Due Diligence Process

For most scratch and dent buyers, due diligence consists of the buyer ordering a BPO on the loan, pulling an updated credit report and performing a thorough review of both the origination and servicing files (e.g., pay histories, collection notes, customer correspondence, etc). Upon completion of the diligence process, the buyer and seller will review any potential changes to the final price due to the diligence findings. Items like valuation, pay history or material credit deterioration may play a role in any repricing that may occur. Clearly, the more accurate the data is on the original tape, the more accurate the final pricing will be. Once the final price is agreed upon, a funding date can be established and a loan sale agreement can be executed between the two parties. Typically, 20 to 30 days are required to complete diligence and to fund the loans. Overall, selling your scratched and dented loans is a very simple process and will result in the company being able to put the proceeds to use in a much more efficient manner (e.g., originating more loans).

Most originators do not have a sophisticated enough servicing department to handle the special challenges of delinquent or nonperforming loans. Keeping your scratched and dented loans presupposes that your servicing department has this knowledge, experience and especially the time required to service them effectively. Servicing these loans is a task best left to an experienced specialty servicer who understands the risks and potential pitfalls. An inexperienced servicing department can quickly put a company out of business.

Servicing needs to be aggressive and swift, with decisive, corrective action taken immediately. Your servicing department is the back door to your business, where dollars can quickly and quietly exit the building in the form of write-offs, protective advances, short sales, REO sales and even legal bills. It may not be the most glamorous part of the business, but it is one of the most critical components to running a successful one. As such, it might just be easier to sell your scratched and dented loans, leaving the real risks to someone else.


 


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