Legacy Second Liens, Once Short of Buyers, Now Lack Sellers

nmn081514secondlien-600.jpg

There was a time years ago when second liens were the toughest legacy home loan asset to find a buyer for in the secondary market.

But today, there aren't enough of these second liens being offered to match buyers' appetites — at least from the perspective of a limited group of fund managers who are looking to buy whole loan pools at a discount, said to Jonas Roth, managing director with MountainView Capital Group in Denver.

One would think those holding seconds would be happy to hear this, with particular nonperforming seconds in danger of becoming uncollectible under certain state laws.

But this motivation doesn't seem to be spurring enough sales to feed existing investor demand, although some deals do trade from time-to-time.

"Supply and demand are not coordinated right now," said Roth. "There are a few handfuls of buyers for both nonperforming and performing seconds who bid very competitively for the few deals that come to market."

Interestingly, although distressed product from the 2005 to 2007 housing boom and ensuing bust has been dwindling over time, the lack of trading supply stems less from a reduction in the outstanding inventory than some other barriers to sales today.

Roth said some banks still have "significant" amounts of nonperforming legacy loans in danger of going out of statute each month, but generally aren't selling them. This may be because they don't find the discount prices the paper sells for worth some of the associated counterparty and headline risk.

Funds have found nonbanks willing to sell, but there have been so many of these trades over the years that it's become difficult for them to get a discount that's high enough to deliver the returns promised to investors. Where they can't find seconds, some have invested in small pools of firsts.

Banks may not be selling because they've already marked down the value of these loans to zero. These write-downs generally occurred during the downturn, when seconds were often underwater and almost impossible to trade. Since then, home prices in many areas have started to recover.

Today, distressed, or once-distressed loans that are now reperforming, have been worth as much as 20 cents to 50 cents on the dollar on the secondary market, depending on the borrower's home equity and payment history, Roth said. That compares to a range of 55 cents to 80 cents on the dollar for seconds that have performed over the full life of the loan.

Nonperforming seconds have recently traded for 30 to 50 basis points, based on the unpaid principal balance of the loan. Once they go "out of statute," that amount drops to 10 or 15 basis points.

"There's still some value, but you now have a loan in many states that is not collectible," he said. "Buyers of these nonperforming seconds are looking for diamonds in the rough. They're looking for the few loans that are going to help them achieve their desired returns."

The fact that fund managers can usually only buy smaller pools outside of the bulk trades that banks typically engage in is another hurdle to bank sales. And counterparty risk is another concern.

"Some of the buyers of nonperforming seconds are companies that a lot of big banks with seconds just won't do business with," Roth said.

Counterparty reviews vary, ranging from extensive written requirements to merely verbal ones, but generally they are a hurdle. In one case, for example, "it is absolutely impossible to get counterparty approval for your new buyer because they just require so much information," he said.

Aggressive collection techniques used by some buyers also can be a concern for sellers if they feel the harm to the customer relationship or their reputation outweighs the gain from a distressed second lien sale.

A sample of lenders' first- and second-lien past dues based on unpaid principal balance from MortgageStats.com shows these are generally low today. (See related chart on 2.) So the recent new second lien boom doesn't help buyers of discount seconds who need product that has been marked down due to flaws or exceptions much.

Today's second liens are much more conservatively underwritten, relative to simultaneous second liens originated during the housing boom, said Suzanne Mistretta, a senior director at the New York-based Fitch Ratings. HELOCs, for example, aren't originated based only on the interest-only or initial teaser rate the way they were during the boom, but rather on full principal and interest payments.

All things being equal, a HELOC has an extra dimension of risk compared to closed-end seconds, so investors may pay less for the HELOC, said Frank Pallotta, the CEO of Ramsey, N.J.-based CMF Management Co. Pallotta is currently working on a Canadian mortgage finance project, but previously worked in the U.S. with distressed collateral and nonconforming securitizations. He still does some work advising banks related to legacy HELOCs, he said.

HELOC buyers not only have to consider whether the consumer has the wherewithal to pay the outstanding balance of the loan, but also whether they want to make other funds available to the borrower according to terms of the original note, Pallotta said.

There are concerns related to pending legacy HELOC resets as well, although some say these open-end second lien reset fears are overstated.

Reperforming and performing legacy seconds are the two areas where the limited group of loan buyers in these sectors seems more eager to buy recently, he said.

"Where you are seeing interest where interest didn't exist before is on reperforming loans, reperforming first liens and reperforming HELOCs. It's not screaming-through-the-roof interest, but it's definitely interest more than we saw a year ago," Pallotta said.

Legacy performing paper that have had high combined loan-to-value ratios, but borrowers who maintained a dependable payment history throughout the worst of the economic downturn, have been particularly popular, he added.

"The definite comeback has been what they call the 'perfect pays,' because I think you pay less attention to the CLTV and the fact that the loan has a 100% loss severity now, and you look at more with you know the borrower and that the borrower has wherewithal to make payments in prior, ugly years."

Prices for nonpeforming sectors are still very low compared to the performing and reperforming sectors, Pallotta said.

"You can get zero recovery, so those still trade at pennies on the dollar," said Pallotta. (One hundred basis points would be equal to a penny on a dollar.)

There are a lot of challenges when it comes to legacy second workouts with performance issues, since by definition, the loans have a secondary claim relative to the first lien, said Robert Shiller, a senior vice president at special servicer Wingspan Portfolio Advisors.

It's difficult to say how many seconds from 2005 to 2007 are passing the point where they are collectible, because state-level statutes of limitations on debt collection vary greatly and have many nuances. But generally, the time limit can range from five to 10 years, starting when borrower payments first falter. Anecdotally, Shiller said he is currently seeing some 2005 product go through this transition.

Buyers may still pay a small amount for these loans even when they are past the deadline, as sometimes there are still ways to collect, though in other cases, it's extremely unlikely, said Shiller. For example, some states ban litigation, but not collections after the deadline, while other states ban both collections and litigation.

Banks are wary of counterparty risk hurting their customer relationships as some collections efforts do pursue widespread litigation against second-lien borrowers, particularly if the investor involved is buying in bulk. There are alternatives such as profit-splitting joint ventures with servicers where collections efforts are more customer-friendly and selective, said Shiller. Borrowers may be willing to arrive at compromises that help their credit, such as modifications, if they are not yet at the foreclosure stage.

"You have to understand who you're selling your loans to," he said.

For reprint and licensing requests for this article, click here.
Consumer banking
MORE FROM AMERICAN BANKER