REO to Rental: Treating the Symptoms and Not the Disease

by Dechert LLP
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photo of Ralph MazzeoEarlier this month I was a panelist at the HOPE NOW REO Symposium in DC. The Symposium brought together residential mortgage loan servicers, community non-profits, private equity investors, government agencies and lenders to discuss the growing number of REO on the balance sheets of Fannie, Freddie and private mortgage lenders. I participated in a panel that focused on how private investors in REO might finance their investment in a pool of REO. One key financing option for investors will be the securitization of the rental income from the REO. Of course, in order to move this forward, we will need rating agency criteria.

A few weeks ago, S&P released considerations for REO to Rental securitizations. One threshold issue is whether the sponsor is structuring the securitization based only on the projected stream of future rental payments or if the proceeds from the property sales are also included in the sponsor's cash flow projections.  In either case, the properties will be transferred to the issuing entity and will be valuable collateral for bondholders. And if proceeds from the property sales are included in the cash flow projections, S&P would also consider home price forecasts and the timing of property sales. S&P also notes that while geographic diversity was always a plus in RMBS deals, the opposite may be true here, where a concentrated pool would be more efficiently managed. Keep in mind too that the core competencies and experience of the property manager and projected operating expenses for maintenance and home upkeep will be important credit considerations. In terms of the rental income, key credit considerations will be the minimum lease term and renewal provisions, an analysis of vacancy and time-to-lease scenarios and rental rate factors such as demographics, interest rates and location. 

We have blogged (here and here) about REO financing and securitization in the past. There is no doubt in my mind that this topic will dominate the residential mortgage space for many months to come. There are many investors sitting on cash who see the REO to Rental market as an attractive way to get yield. Warehouse lenders are also eager to get into this game.  The warehouse lenders may only be willing to lend up to 50 or 60% LTV on a pool of REO in the current regulatory and economic environment.  Nevertheless, there is plenty of demand from private equity shops and other investors in the process of acquiring REO who could always use some leverage to improve their yield.

We’ve also discussed at length (here and here) the recent offering by Fannie Mae of pools of REO (with requirements that the purchaser rent out the homes for at least three years before selling) and the key considerations for bidders interested in acquiring one or more of those pools. With respect to the Fannie offering, note that in recent testimony before the House, Meg Burns from the FHFA made it very clear that this initial offering is just a pilot and should not be construed as an indication that Fannie will abandon its reliance on existing retail sales strategies as the primary vehicle for liquidating its REO inventory. It seems like the government was shocked by how much interest there was in the offering and wanted to reset industry expectations concerning the pace of future government sales. In any event, the genie is out of the bottle. 

Am I excited about all of this activity surrounding investments in REO? Yes. Do I think this offering by Fannie Mae will influence how banks dispose of their own portfolios of REO? Yes. Do I think there is a larger problem looming behind the headlines surrounding REO to Rental? Yes.

That problem is how to slow the rate of delinquencies and mortgage foreclosures. Offering pools to encourage the REO to Rental strategy is a great initiative and the industry should continue to pursue it. It’s a smart way to reduce the oversupply of housing in distressed markets and meet the demand of families who are no longer able to qualify for purchase money mortgage financing. Nevertheless, we can’t lose sight of the mountain of delinquent mortgage loans that have not yet been converted into REO. The question is how do we accomplish “delinquent mortgage loan to Rental” and thereby prevent the next wave of REO from hitting the balance sheets of the GSEs and the private banks. There may be 500,000 REO on the books of Fannie, Freddie and private banks but there is a shadow inventory in the pipeline of 3 million borrowers who have not made a payment in over a year. The continuing high default rate that has persisted throughout the credit crisis is the disease that needs to be cured. This high default rate is made more problematic by the fact that it often takes well over a year to foreclose on a defaulted mortgage loan. While this delay may benefit the individual borrower for some period of months, the ultimate burden falls on the GSEs and the private banking system whose collateral deteriorates in condition and value in the meantime, further compounding losses. Before we can see a meaningful bottom to housing prices and truly see prices stabilize, we need wage increases, more credit and more employment opportunities across the board. This problem is too large to solve with targeted programs. We need to grow our way out of it by changing our overall economic and fiscal policies.

But in the meantime, there are deals to be done and many opportunities for us lawyers to get involved...

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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