There is a wave of interest and activity in pools of non-performing and re-performing residential whole loans (NPL/RPLs) that many distressed investors are looking to ride or are already “hanging ten” on. Given the high-touch servicing required, the ocean of data from potentially multiple servicers, the need for data aggregation, normalization and validation, and the risks of non-compliance, we think investors and their fiduciaries require a systematized approach for loan servicer oversight to minimize risk and optimize returns in this novel and growing asset class.
1. NPL/RPL Demand: Increasing in 2014 and beyond
Distressed mortgage investors have shown increasing interest and activity in NPL/RPL whole loan pools over the past year, a trend that we see likely to continue over the next few years for a number of reasons. Let’s begin with the demand side of the equation. Since 2008, some 40-odd hedge funds focused on structured product have made stellar returns in non-agency mortgage-backed securities. While there still may be a bit of “juice” left in that trade, it’s probably safe to say those lemons are close to being squeezed out. Today, fast-rising assets under management from gains on those trades, plus new investor inflows, have created a need for new avenues of capital deployment. As a result, many of these same funds have shifted their attention to less-traveled and picked-over areas of financial crisis rubble: commercial real estate/commercial MBS, collateralized loan obligations, and increasingly, NPL/RPLs in the residential space.
Add to that the increasing number of players operating in the REO-to-rental space — led by industry giants like Blackstone with a roughly $9 billion commitment to RtoR — this is a market that appears here to stay. Last year, IMN’s inaugural RtoR conference in Florida had 800-plus attendees, the first securitization of RtoR rental payments printed in October 2013 was oversubscribed several times over and more deals are in the pipe. The demand for REO property from these opportunistic funds has lifted home prices and crowded out first-time buyers in some cities, but with leverage available and increasing familiarity with the asset class, RtoR fund operators are sourcing NPL/RPL pools as a way to access and buy rental properties en masse.
Lastly, traditional players like asset managers, insurers and private equity firms with significant experience in credit-sensitive residential MBS are also increasingly active. Many see this NPL/RPL activity as a natural extension of their core competencies. So taken together, the demand side of the equation is clearly strong.
2. NPL/RPL Supply: Is 2014 the Year the Spigot Opens?
A recent article in an industry trade journal focused on securitization indicated that the supply of NPL/RPLs traded in 2014 is poised to finally take off after high expectations for distressed loan sales that were never quite realized since the crisis began. There are three subreasons for this:
1. Prices for pools have firmed in recent years against the backdrop of improvements in home prices, a reduced foreclosure backlog and increased demand. Increased selling by large mortgage banks, like Wells Fargo, Bank of America and Citibank, seeking to shrink their balance sheets and the capital required to hold NPLs with Basel III’s 2015 phase in.
2. A growing investor acceptance for securitizations of NPL/RPLs: in 2013 some $4.2 billion of NPLs (34 deals) were securitized by Wall Street dealers, double 2012’s tally, and several deals have printed year-to-date.
3. Larger/more frequent sales from HUD are expected as the housing agency seeks to reduce losses at the Federal Housing Administration. As of November 2013, U.S. Department of Housing and Urban Development sales of NPLs totaled $8 billion since the start of 2010, and since then the agency has sold an additional $6.6 billion, with more expected.
In turn, it’s estimated by the Federal Deposit Insurance Corporation that U.S. banks hold some $240 billion in NPLs, a strong indicator that the supply side of the equation should be there as the market continues to develop.
3. NPL/RPL Specialty Servicers: Ready for the increase in activity?
Just last week, a $39 billion transfer of mortgage servicing rights to Ocwen from Wells Fargo was blocked indefinitely by the New York Department of Financial Services, the state’s banking regulator. In its complaint, the NYDFS cited concerns over Ocwen’s ability to handle the additional business, in effect suggesting that Ocwen, the fourth-largest servicer in the nation with some $230 billion in loans serviced, may not have the capacity to properly service the additional loans.
For investors in NPL/RPL loan pools, Ocwen is probably not the first choice for servicing. Smaller specialty servicers that deal predominately in distressed pools probably are better candidates. And if the additional investment activity envisioned materializes as forecast, then capacity for these servicers will clearly be an issue as well. Taken together, this means investors in distressed NPL/RPL pools need to be even more vigilant in their loan servicing oversight – underscoring even more forcefully the need for a systematic approach.
4. NPL/RPL Asset Managers: Optimizing returns/minimizing risk with systematized approach
Against this backdrop, it’s clear that increasing demand should be met with ample supply, thus clearing the runway for the aforementioned funds and other players to get involved. But before folks dive right in, it’s important to note the requirements for success in this complex asset class are very different than non-agency securities investing. While having a Bloomberg, a subscription to Intex and an Excel spreadsheet were fine for buying CUSIPs, portfolio management of NPL/RPLs has been likened to “hand-to-hand combat” by seasoned whole loan traders. It’s far more time-consuming, labor-intensive and idiosyncratic. The effort required is higher, which makes efficiency the key to success.
Because good portfolio management seeks to maximize returns while minimizing risk, it’s critical to understand which loans need immediate attention and can be advanced toward resolution: whether that’s a short sale, property foreclosure, loan modification or repayment plan.
The risks an asset manager faces in this process are many and include, among others, failing to understand which borrowers are likely to perform and which ones are using loss mitigation to merely stall the inevitable, ignoring state or local loss-mitigation initiatives that can lead to borrower litigation, or failing to stay on top of foreclosure attorneys so that the foreclosure action is processed on a timely basis.
Given all the trends and factors outlined above, it’s clear investors and their fiduciaries should require a systematized approach, one that allows asset managers to oversee and indeed manage their servicer’s activities. Toward that end, a proper loan servicing oversight system should offer 9 things:
1. Storage of all relevant due diligence files for easy access during the asset management process from seller-provided information to vendor results, including compliance reviews and data scrub tapes, title/lien search results, BPO reports, prior servicer notes and pay histories.
2. Automatic loading of daily servicer loan tapes where the data is aggregated and normalized along with data from the due diligence review.
3. Pre-built data validation queries designed to uncover inconsistent or missing data points.
4. A suite of queries designed to uncover servicing practices that might be detrimental to your portfolio, including queries designed to spot “dual tracking” or ensure that foreclosure milestones are met in a timely manner.
5. Ability to create ad hoc queries or priority lists of loans for tracking or surveillance.
6. Ability to support multiple portfolios across pool holdings so tracking performance and reporting is made easier.
7. A series of “dashboards” in a user-friendly graphic user interface that allow the asset manager to view timeline trends in real time, such as the monitoring of delinquency transition rates across portfolios and the capability to “drill down” to assess any problems and prioritize those loans which need attention first.
8. Retain all records of loss mitigation efforts and borrower contact attempts to ensure compliance with various government and other loan modification programs; retain important documents.
9. An internet-ready cloud-based solution (SaaS) rather than a hosted application. The benefits of this approach are well documented and include access from multiple locations, ease of deployment and rapid upgrading, along with a system that can be scaled more easily.
5. Loan Servicing Oversight is Necessary: So Build or Buy?
Finally, a systematic approach to loan servicing oversight is a necessary component to implementing a successful NPL/RPL investment program. As with any effort requiring tools, decisions must be made on whether a system should be built from scratch or if there is an off-the-shelf solution that can be installed more rapidly and efficiently. For investors like hedge funds who may plan on investing in loans as a portfolio add-on where NPL/RPLs will be another strategy deployed among many, renting or buying a solution makes the most sense. In addition to saving time and money and getting ramped up more quickly, it allows the asset manager to focus on their core value-add and not on systems development and deployment. There’s also the issue of how long the strategy will be in place. For strategies that have a medium-term horizon and untested viability, building out a system from scratch is not the best option.
In our analysis, we’ve made the case that activity in NPL/RPL residential loan pools is likely to pick up, perhaps substantially, as the forces of supply and demand come together meaningfully. Unlike investing in distressed RMBS securities, distressed loan investing is a different kettle of fish: efficiency is paramount and the risks of not employing a systematized approach are clear. Specialty servicer capacity may become an issue as the market continues to develop, and aggregating, normalizing and monitoring data from several sources is probably best handled for most investors by using an off-the-shelf cloud-based system that’s available and scalable. Asset managers who want to succeed in this space should review their options for loan servicing oversight systems and plan accordingly.