Thinking about purchasing distressed assets?  It’s an area that has drawn a great deal of interest lately.  A recent Google search for “distressed assets” produced 510,000 results.  The term can mean any one of a number of things, depending on who’s talking and who’s listening.  Distressed assets can include mortgages, credit card portfolios, car loans, boat loans, or even the real property itself.  In this post we will provide suggestions on what to keep in mind when considering purchasing distressed, delinquent, non-performing mortgage loans.

The sale of non-performing mortgages is currently a seller’s market.  Potential buyers beg lenders and servicers for product, and when portfolios do come to market, the winning bids have been higher than expected.  While all this makes for less activity than some would like, who knows what the future holds?

An hour from now we could learn that Treasury has done an about-face and will purchase underwater mortgages after all.  Maybe accounting treatments will change, allowing  banks to sell non-performing mortgages without posting heavy losses.  In any case, a prudent buyer would do well to be prepared when the market opens up.  Historically, those who do their homework achieve success.

Here are some areas to consider when purchasing today’s troubled mortgages:

PRE-PURCHASE DUE DILIGENCE
The amount and quality of information provided to a prospective buyer varies widely.  It’s reasonable to expect that a seller, agent or auctioneer is apt to provide as little data and detail as possible with regards to the individual loans.  You have to work with what you’ve got.  For instance, what does the tape tell you about a particular pool?  When you scan the data, does anything in particular jump out at you?  What could it mean?  Is there any way to further investigate possible anomalies?  Is there anything unusual (good or bad) that could affect the bid price, reps and warrants or other consideration?  How many servicers are involved?  How many lenders?  Where are the properties located?  How homogeneous is the pool?

PROPERTY
Determining present value of the property is a huge task in today’s market.  Collateral (real estate) values are the elephant in the room for anybody who is considering this type of venture.  The most comprehensive way to accomplish this is to carefully review available BPOs and/or order new ones, along with Internet research to determine comparable sales, listings and ownership.  Also important is determining the validity of the original appraisal.  Did the property exist when the loan was made?  Does the appraisal apply to the correct property?

The use of a trusted BPO company is paramount.  Not all BPOs are created equal.  While the price of the BPO can be a factor – this is one area where you don’t want to scrimp – equally important are turnaround times, ability and willingness to answer questions and provide feedback, and additional services such as occupancy check.  Occupancy is an important factor in determining likelihood of a workout.  There are a number of ways to determine whether the borrower is occupying the property as his primary home.  This information is invaluable in determining how to proceed once you own the loan.

BANKRUPTCY SEARCHES
Has the borrower had a bankruptcy filing?  When?  What type?  What is the current status of the bankruptcy?  It makes sense to perform your own bankruptcy search; the borrower may have filed yesterday.  In any case, you may not yet have the servicer’s records, or they may not be current when you do get them.  What if every borrower in the pool filed bankruptcy?  Not likely, but worth thinking about.

LEGAL TRAIL
Does the chain of title run to the lender who is selling the loans?  Are the mortgages recorded and valid?  Buyers of mortgages have a tendency to take this for granted.  It could cause you a problem.  Late last year a judge in Ohio invalidated a number of foreclosures because the holder of the notes could not prove ownership of the loans.  Imagine that you purchase a group of distressed mortgages and some of them proceed to foreclosure.  You go forward with foreclosure, only to find at the last minute that your interest is not perfected and that the chain of ownership is invalid.   Chances are you won’t be able to move forward, and you will have to spend time and money to correct the problem.

SERVICING
Has the collection, default and foreclosure process to date been in statutory compliance?  It would be judicious to review servicing and collection records to determine whether state, federal and even city and county mandates have been complied with.  In recent months, many states, counties and municipalities have enacted mortgage loan servicing requirements that, if not followed precisely, could have grim consequences.   In addition, what is the status of each loan?  How far into the process is the loan, and what are the remedies?  Is a loan that’s represented as 90 days delinquent really 90 days delinquent?  These issues can be expensive; a servicing review on a loan-level basis alleviates the possibility of a costly surprise somewhere down the line.  

Chances are that your servicer is overwhelmed and unprepared to meet today’s challenges.  Servicers are encountering volumes of additional work and responsibility the likes of which were never anticipated.  It’s your responsibility to make sure that the status of each of your loans is what you think it is. 

WORKOUTS
This is the biggest challenge facing investors and servicers today.   Much has been published about extraordinary methods of communicating and negotiating with borrowers.  These methods wouldn’t have been needed or even anticipated a year ago.  Each investor has a different philosophy about how the communication issue should be approached.  Your ability to convey that philosophy to counterparties, and their willingness to carry out your wishes, is vital.  In addition, it may be up to you to determine which borrowers are worth approaching and which are not.  If fraud was committed, you may not be able to contact the borrower at all.  Knowing early on that fraud is a possibility works in your favor.

COMPLIANCE
Imagine this scenario:  you buy a pool of loans and begin to work with the borrowers to modify the loans that warrant it, at the same time proceeding with foreclosure on loans where modification is not possible.  One of the borrowers decides to pay to have a “forensic audit” performed on his loan.  During the forensic audit, it’s discovered that, at the time of origination, a violation of the Truth in Lending Act occurred.  The borrower obtained a cash-out refinance of his primary home, and the Right to Cancel (commonly known as the Right of Rescission) was not executed correctly.  The validity of the loan from the time of origination is in jeopardy; the right to rescind may be deemed still open, even years after the loan was closed.  Now go one step further and imagine that the attorney who ordered the forensic audit  assembles a class.  He initiates a class action lawsuit against the originators, servicers and owners of this pool of loans.  You get the idea. While this is an unlikely example, today’s news is full of extreme cases which nobody ever thought would occur.  A compliance check to substantiate conformity with RESPA (settlement procedures), TILA (disclosure of APR, right of rescission) and a review of the title to determine the status of the lien and exceptions to the title may be money well spent.

REPS AND WARRANTIES

Right now you may be saying to yourself, “But I’ll have reps and warranties for some or all of this.”  Now may be a good time to remind yourself that reps and warranties, as always, are only as strong as the seller itself.  In the recent past we’ve seen that no institution is safe from takeover, bankruptcy or oblivion.  A prudent investor will proceed as if his reps and warranties may be limited or non-existent in the future.

Many opportunities exist to gather and process valuable information.  It’s up to you to decide how extensive your research will be.   They say knowledge is power.  In this case, knowledge is money.  If you are armed with as many tools as possible, you can move forward with confidence that you’ve done everything possible to protect your investment and make money going forward.

www.nytimes.com, Gretchen Morgenson, Foreclosures Hit a Snag for Lenders, November 15, 2007.

April Smith is the owner of April Smith & Associates, Inc.

She has over three decades of multi-layered experience in the field of mortgage finance.  She founded the firm in 1988, and she continues to provide hands-on strategy and planning for both new and established clients.  She is an active speaker and educator to the industry.  April is a recognized authority on mortgage due diligence.  You may contact April via her website.