Banks and other lending institutions often sell outstanding loan obligations to investors and buyers who are looking for income streams or other access to cash-flowing assets. The sellers sometimes need to turn long-term income assets into cash, and will usually discount the anticipated loan interest payments in exchange for immediate cash or cash equivalent. Investors may purchase these loans for a portfolio investment or to package them and sell ownership in the form of bonds or investment fund shares.
In today's marketplace, the balance sheets of many commercial, investment and savings banks are filled with loans that the institutions may need to sell for a variety of reasons. These reasons may include that the institution has reached the limit of such loans that the government deposit insurance agency allows before being forced to raise the cost of insurance premiums for the institution.
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There is, however, a gap of information between many investors who would like to buy these loans and the representatives at the lending institutions who wish to sell at acceptable prices. The price at which a deal is struck is commonly called the marketplace execution price.
Finding that execution price is a major challenge under current market conditions, because buyers with cash want to buy all loans at a substantial discount, while sellers want to get the best possible price. The standoff is at the core of why the financial services sector – especially the mortgage lending and investment business – is in turmoil. But a basic understanding of what goes into the pricing of loans and the decisions to buy or sell them is critical to solving this standoff.
Performing loans
For investors, purchasing loans can be a cost-effective way of acquiring these assets while avoiding the costs usually associated with originating them. In the case of mortgages, for instance, the cost of collecting all the initial paperwork, underwriting the loan, obtaining title reports, paying for legal counsel at closing and many other line-item expenses during the closing process can add up to as much as 3% of a loan's value.
Therefore, based on the value of the loan – and in the case of mortgages, the value of the collateral – a buyer will pay a negotiated price for the loan. Anticipating that the borrower in the loan will continue to pay interest and principal for the foreseeable future, the loan investor (as the buyer is usually called) will calculate an acceptable return on investment that will justify the loan purchase. This is usually the basic process for acquiring a performing loan, where the borrower (also called the counter party credit) is making timely payments to the lender.
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Nonperforming loans
Nonperforming loans represent another type of asset a buyer can acquire. A nonperforming loan is the name given when the borrower is officially in default and not making payments. Different institutions measure official default by different standards and numbers.
For instance, one lender may consider a loan officially in default after a borrower is more than 31 days late with a payment. In other cases, a lender may consider a loan officially in default after being 90 days past due.
The investment strategy for the buyer, in this case, is to pay a discounted price for the value of the outstanding loan, with the anticipation of collecting the balance (or an amount close to the balance) from the borrower. Nonperforming loans are discounted based on a number of variables, including the credit rating of the defaulted borrower, the number of days the loan has been in default and the circumstances that caused the borrower to go into default in the first place.
A lender will choose to sell a nonperforming loan simply to avoid the administrative costs that may be involved in collecting the outstanding amount. The lender may also sell the loan because the lender has determined that recovery is doubtful. This is often the case when an institution holding the loan anticipates that something drastic may happen, such as the likelihood the borrower will file for bankruptcy protection.
If the lending institution believes that the borrower does not have the wherewithal to recover from the credit default and that the cost of keeping the loan on its books will have a negative impact on its income statements or balance sheet, then a decision to sell the loan is quite likely.
Subperforming loans
Subperforming loans represent another investment opportunity. In this case, the loans are not discounted as deeply as nonperforming loans are, because the borrower may only be delinquent or payments might be coming in slowly and off schedule. Here, the bank or lending institution will sell ownership of the loan (also referred to as unwinding its position in the loan) before the loan becomes a nonperforming asset.
In this case, the buyer will negotiate a price for taking over the seller's exposure to the loan and become the new owner of a somewhat performing asset. Sometimes called scratch and dent loans – especially in the consumer finance and residential mortgage world – subperforming loans can be very profitable for the buyer who knows how to service these assets and manage the borrower's repayment habits. This business strategy is often referred to as a ‘high touch’ loan servicing business, where the buyer of the loan will maintain close and in constant contact with the borrower to keep the asset performing at a minimal level.
A subperforming loan is also somewhat easier to cure than a nonperforming one. The delinquent borrower may also be able to better meet payment obligations if a loan is modified or has its interest and principal payments rescheduled. The pricing of this loan, for instance, is based on whether the buyer believes the reasons for delinquency are curable. The reasons can range from the borrower having a history of short-term cashflow problems to if there is a documented way to verify that the borrower has seasonal changes in income.
Asset valuation
At the heart of any decision to purchase a loan is the anticipation of the value of the loan or collateral. The asset that may back the loan is almost entirely the driver behind the pricing, even though when it comes to consumer loans, there are some lending laws that come to bear. In the case of a commercial loan, for instance, purchasing a loan based entirely on the value of the underlying asset or the business cashflow of the borrower is an easy decision and the industry standard.
However, in the case of consumer loans – especially residential mortgages – the very idea of an investor publicly stating the intent to buy a loan based on the value of the underlying collateral (such as a borrower's primary residence) is enough to bring a swarm of FBI agents to the investor's front door. This is the result of today's unpredictable political and economic environment that has all financial services participants on edge.
Therefore, asset valuation in consumer loans is often either not mentioned at all, or otherwise restated in loan servicing and customer service jargon. A buyer of consumer loans will do well to disclose that the buyer ‘intends to work with the borrower to reach a resolution to the delinquency or default.’
So, ultimately, the strategy behind a decision to sell or purchase a loan or portfolio of loans will take into consideration all the factors that affect the pricing. When approaching a potential counterparty in a loan trade transaction, the buyer or representative of the buyer will do well to comb through the credit of the borrower. The buyer will also do well to identify the reason for delinquency or default, the financial wherewithal of the borrower(s) to repay the debt obligation and the value of any collateral for the loan.
Loan workout and default resolution should be the key components to a buyer's decision when it comes to nonperforming or subperforming loans. And that decision will be driven almost entirely by the nature of the type of loans being considered. The different types of loans – performing, nonperforming or subperforming – will each demand an entirely different pricing and investment strategy.
And while asset valuation is critical, may the buyer beware when counting on the value of the collateral that backs a consumer loan being acquired. The industry's term for this dicey awareness is ‘lender liability,’ and this can wipe out an unsuspecting investor in short order.
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W. Joseph Caton is managing director of Hartford One Group, a financial services training and development firm based in Oxford, Conn. He can be reached at jcaton@hartfordone.com.
