Household finance reo

In line with the cyclical nature of real estate loan industry, a major structural change in the investment criteria of opportunity funds and the credit policy of banking concerns is occurring. As a strategic alternative to workouts and foreclose-and-sell approaches, leaders and loan portfolio purchasers are increasingly selling small and medium sized pools of performing and non-performing loan assets into the investor market, using experienced loan sale advisors. This is an indication that the laws of supply and demand are causing market-clearing prices for these loan assets, prices where both buyer and seller leave the closing table satisfied.

A driving force in the success of a loan sale is retaining a loan sale advisor whose presence in the marketplace will ensure a competitive bidding scenario, with the competition being between earnest buyers. Clearly, when a major $250 million principal balance loan portfolio is coming to market, the major investment banking players will attend the "war room," perform their file review, and bid aggressively to acquire such assets. However, will a smaller sale, involving say $25 million to $100 million principal balance in assets stratified into $5 million to $10 million pools by geography and asset type garnet the same amount of interest and competitive bidding from the same large investment banking firms? The answer is obviously no.

Outside of Wall Street, there exists a word of smaller opportunity funds and investment companies which have been set up to acquire and work through loan assets over the course of the last three years. These funds are not household names and each specializes in a particular area or in a particular asset type. These relatively smaller groups are highly specialized entities capable of bidding more aggressively than larger investment banks on particular loan asset pools because era "small firm" competitive advantage and the resulting lower yield requirements. A successful price maximizing and IRR maximizing smaller balance loan sale thus results from use of a loan sale advisor familiar with such "non-household name" buyers.

Loan sales also have a positive effect on internal rates of return and/or profitability for both lending institutions and loan portfolio purchasers for a number of reasons.

The most attractive reason for selling loans now is the combination of the liquidity in the distressed asset purchasing market and the relatively low cost of capital. The liquidity in the marketplace is the result of a high investor confidence in real estate as an asset class, a massive infrastructure remaining from the RTC and FDIC servicers, and an enormous amount of capital made available by Wall Street. Because of these numerous and ready sources of capital for investment in loan portfolios, investors also benefit from the high leverage that competition among lenders causes. The low cost of money also allow lenders to the distressed asset purchasers to price the increased risk into their loans and still lend at respectable spreads above LIBOR or comparable Treasury securities, mitigating risk and increasing loan IRR with innovative structural and participation characteristics.

From a lender's point of view, a present value analysis of foreclose-and-sell costs versus immediate loan sale proceeds makes an attractive case for selling loans now. The true hard and capital costs associated with owning, managing and selling real estate owned (REO) are being scrutinized as the health and profitability of the traditional lending industry returns. Teams of distressed asset servicers and traditional owners have entered the marketplace with cost-effective streamlined systems of asset administration that allow for aggressive pricing approaches relative to bank or lending institution book values.

For investors in distressed loans, the time limitations of many investment entities and partnerships dictated specific shorter-term holding periods to begin with. Loan sales expedite cash out and when the typical 24 to 36 month resolution schedule must be adhered to, they satisfy investment criteria. This is done primarily with cost reduction. Loan sales minimize the transaction and foreclosure costs associated with foreclose-and-sell approaches. In general, commissions are significantly less than those paid on traditional real estate sales. Lengthy litigation costs are eliminated. Transfer taxes are avoided. Real estate tax and water/sewage arrears do not need to be paid from working capital. Interest costs are reduced significantly. In addition, hard cost risk is avoided on non-strategic loan asset sales.

Both higher balance ($1 million+) and smaller balance (less than $1 million) assets lend equally well to loan sales. Larger balance cash-flowing assets allow investors to price assets as close to market value as possible, because value is easily ascertainable. Cash flowing assets also compel particularly aggressive bidding. Smaller balance non-cash flowing assets, particularly those with limited workout possibilities, present greater foreclosure and workout headaches to lenders relative to the reward. All maintenance costs for these assets become non-recoverable expenditures. Localized and specialized operators and investment groups are best equipped to maximize profitability on these types of assets and pools, and thus are in the position of being able to pay the most for the opportunity to do so.

In sum, loan sales of $25 million to $100 million of performing, non-performing, re-performing and sub-performing loans can be utilized in a number of strategic ways: as a portfolio re-balancing tool, a workout tool, or as a regular disposition tool. A loan sale compliments the efforts of a workout or sales team, rather than preempts that effort, by allowing team members to focus their energies where profits or priorities warrant. A mortgagee knows its assets best, and by hiring the appropriate loan sale advisor, the mortgagee can fully access the market for its assets, and get the best price.

The Carlton Group, Ltd. sold and/or financed approximately $200 million of loans in 1995 for some of largest financial institutions and loan servicers in the country.

Howard L. Michaels, Chairman and Wm. David Tobin, Senior Financial Analyst, The Carlton Group, Ltd.