Happy (Subprime) REO Tales
April 1, 2000
This was orginally published in xxx xxxxxxxx.
Tom F. DiMercurio is executive Vice-president, Chief Operating Officer, of Castle Advisors and Castle Advisors Mountain States, Inc. (a Chicago Title Company); National Default Strategies Advisors, Chicago Title Company, Lender Source Division. During his career, Tom has managed well in excess of 30,000 REO dispositions.
It doesn’t take a Cinderella, Prince Charming or even walking down the yellow brick road to have a successful REO operation. Following certain “do’s and don’ts” and other advice will help deliver effective REO results.
Just as a particular song or style of music often defines a year or a decade, the volume and quality of real-estate owned (REO) assets over the last few years of the 20th century and the beginning of the new millennium has made an indelible imprint. This period has – and will continue to be – a mirror into the practices of the subprime lending industry, giving a picture of the typical subprime “bad” loan.
Many of these practices (in sub-prime loan origination and servicing) simply exacerbate the migration of bad loans into REO. The REO servicer, manager or third party outsourcer who is familiar with the lending inadequacies and excesses of the subprime world is better served with such strategies as mitigating loss per case, accelerating sales and providing professional real estate representation.
REO assets have always represented what can be described as the “bad and the ugly,” (the best of the “bad” loans having been worked out or otherwise settled). The lack of defined and prudent lending parameters has generally spawned subprime REO assets which are considered by many asset managers to be not only bad and ugly, but extremely challenging and reflective of both high loss frequency and severity. These parameters include programs with unrealistically high LTV’s, inflated appraisals, rampant fraud, the reliance on self-regulation and inadequate default servicing practices.
My own experience as the manager of property disposition sales for Fannie Mae in Houston from 1986-1988 illustrates the difference in the current REO model. While Houston can be characterized as a collateral disaster (based on overbuilding, the oil decline and an associated free fall in market value) the REO housing stock was relatively new (less than 10 years old), located in desirable areas and neighborhoods where people actually wanted to live.
Once the price/demand equilibrium was met, REO assets in the Houston marketplace left investor/servicer inventories at a record level at the market determined value.
In contrast, current subprime REO represents the result of both a credit and a collateral fiasco. Too many loans have been – and are being – extended to borrowers with an extremely risky credit profile, without many of the same assurances that are required in the defined secondary market for conforming loans, in areas and locales where no one wants to live or where the market is very thin on assets which often fail to meet minimum acceptable property standards.
Say what you will about the GSE’s, but their absolute power of repurchase for non-adherence to program parameters has worked well in insuring that the vast majority of their acquired properties are marketable, without suffering many of the legendary inadequacies of the subprime world.
To be sure, the best real world method to reflect on and determine actual lending practices is to evaluate the throughput or the back end of the subprime-lending continuum – the REO spawned by the subprime machine.
This process provides a dark reflection through a clouded mirror of convoluted or non-existent quality control checks. Analyzing the throughput, (subprime REO) is customarily the starting point for the Office of the Comptroller of the Currency (OCC) and Office of Thrift Supervision (OTS) as they commence “safety and soundness” audits of sub-prime lenders under their jurisdiction.
A comprehensive review of each standard and prudent credit and collateral underwriting parameters, past payment history, and may have been closed without the benefit of normal title requirements.
Much has been made of “risk-based pricing” employed in the sub-prime lending model. In theory, one should be able to assess the appropriate level of risk, assign each loan a unique loan specific, risk-based price and thus assure oneself of an acceptable spread and marginal profit.
In practice, of course, the debacle and fallout (bankruptcy and near insolvency) of most of the large subprime players indicates the real gap between the theory and the reality of risk-based pricing in the subprime arena.
Despite record economic prosperity across every recognized barometer and index, America’s mortgage legal service providers (attorneys and trustee companies) report record business. They also universally report that as a class, subprime loans are a microcosm for every kind and character of lending flaw: from over appraisal, to inadequate documentation (including a high percentage of loans which secure the wrong or no collateral), inferior lien priority to that anticipated, and properties without basic services such as water, sewer, ingress and egress.
I hear these stories at conferences and seminars, and in my frequent conversations with the most active and foremost foreclosure, bankruptcy and eviction specialists around the country.
I believe strongly that the quality of REO assets in 2000 and beyond is and will be far inferior to that of prior REO “periods.” It will require not only innovative preparation, anticipation of typical problems, and creation of a high-level feedback loop back to the originating units and its executive management, but many of the rules of REO loss management bear re-iteration and re-emphasis – even in a subprime world.
during the default cycle (and every company has some), the goal should be to price aggressively and liquidate immediately. Assets located in poor locales, declining inner city neighborhoods, remote and rural locations and older mobile homes are prone to repeat vandalism and citation from the local municipality
Don’t try to chase the last dollar. In so doing, the imbedded loss will almost always increase. Reliable values on these asset classes will be difficult to obtain. Focus on properties where you can make a difference.
The challenge in the Houston marketplace in the late 1980s was to correct the image that a foreclosed asset was a bad asset. And then to speed these properties along to a new batch of homeowners who recognized value and who would perform. For Fannie Mae it was primarily a velocity game: close to new owners more assets than you acquire each month from seller-servicers.
There is both a short and a long-term solution to reducing loss frequency and loss severity in subprime REO. On the short term basis, I believe strongly that REO asset managers and REO outsourcers must deal with whatever is in their inventory.
It’s always enjoyable to point fingers and to focus responsibility elsewhere (and surely there are many directions in which to point), but once an asset enters REO, it must be dealt with. Dedicating oneself to finding real world solutions to seemingly intractable problems is both time-consuming and rewarding. And it must be done on a daily basis with an asset-specific focus.
For the long haul, originators must finally realize that, not all borrowers are credit-worthy and that not all properties are acceptable collateral. When virtual non-regulation is supplanted by reasoned self-regulation and when risk-based pricing is a reality, then many of the excesses of subprime lending will be eliminated and thereby many of the difficulties of subprime REO management will be gone.
Rest assured that the definitive book, as far as I know, has not yet been written on subprime REO. What I love most about the REO business, and the subprime component in particular, is that every day is ripe with interesting new property specific marketing challenges.
Each new portfolio or client offers a chance to learn something new. and these multiple opportunities are what challenge creativity and foster, in me at least, a relish and zeal for the assignment which has rarely diminished over 25 years in the management and administration of defaulted assets.
Those of us in the business will continue to roll up our shirt-sleeves, wrinkle our brows, and curse quietly under our breath, secretly blessed with the knowledge that we are the “ultimate” loss mitigators.
Conventional Wisdom: First and Best Losses
It is my opinion that overpricing is the single greatest cause for controllable increased loss severity in REO assets.
Nowhere is the oft quoted adage: “First Loss... Best Loss” more applicable than in the administration of REO assets. Being able to recover a loss early is preferred because holding costs are high, market conditions variable and later recoveries uncertain.
For many experienced asset managers, this phrase has become the conventional wisdom. To the next generation of REO managers, I commend this single thought as the overriding imperative to controlling REO losses.
No amount of serendipitous good fortune will make up for an asset too long in inventory.
Moody’s writes in its Structured Finance While Paper dated March 20.1999: “Belayed losses mean higher losses.” Anil it is my opinion that overpricing is the single greatest cause for controllable increased loss severity in REO assets (here the distinction is made between origination controls – as in an unreasonably high and unsupported value and controls in REO).
Here, then, are my “do’s and don’ts”:
- Don’t fight the origination appraisal. It was probably too high and encouraged by the incentives paid to those highly com pensatcd loan officers.
- Don’t place too much emphasis on the REO appraisal. If overpricing is the single greatest contributor to increased loss severity, then blind acceptance of the appraised value is the culprit. The same appraisers who author those “high” origination appraisals complete many REO appraisals.
- Don’t always “go for the last dollar.”
- Do select the best brokers (market area specialists) and/or outsource firms who are trained and specialize in REO.
- Do treat brokers and outsourcers fairly and cultivate their loyalty and support. They are an important part, of the solution and can add real value if managed appropriately.
- Do begin marketing even before the foreclosure sale by bringing the broker into the loop immediately before the foreclosure sale. Many of the best. REO brokers prepare lists of upcoming properties and have offers waiting for the seller once the list price has been established.
- Do start cash-for-keys (CFK), also known as relocation assistance, even before the foreclosure sale is completed.
- Do initiate evictions immediately while offering CFK.
- Do immediately begin title curative by ordering and carefully reviewing post-foreclosure title commitments.
- Do develop a repair philosophy which is consistent with the loss minimization goals of your company
- Do price aggressively, somewhat below the most competitive listings in the area.
- Do counter – but don’t be afraid to take and to negotiate the first offer. Research validates that the best reception a property will have is when it is first exposed to the market.
- Do identify problem properties and craft individual sales strategies.
- Do try auctions, sealed bids or alternative disposition strategies for special classes of assets.
- Do know and publish internally the daily cost of holding an average REO asset in inventory.
Top Ten Things I Hate About Subprime REO
Sure, there are plenty of “pesky little problems” uniquely associated with subprime real estate-owned (REO), but I love tins product type. Without it. as a third party provider of REO services, I'd have limited business and I'd likely be unemployed.
With apologies to David Letterman, here is a top 10 list of REO problems:
- Origination appraisal: $100,000, pre-foreclosure value: $85,000; current REO appraisal: $65,000, current REO BPO: $20,000;
- A previously unknown final demolition order arrives concurrent with the recordation of the foreclosure deed;
- The average marketing lime for the subject is not measured in days on market but years on market;
- Although the former borrowers are gone, the ejectment action to be commenced is focused on removing two deer, three squirrels and a porcupine;
- The only broker in a fifty mile radius of the acquired asset thinks the World Wide Web is an Israeli conspiracy. and that “hi-tech” means having a cell phone;
- There’s no need to winterize this asset. The bathtub is a solid block of ice;
- Broker to servicer: “The good news is we've located a water source. The bad news Ls that it’s on the property owned by the ex-mortgagor’s father-in-law”;
- Broker to servicer: “It’s a bad lot, and you didn’t foreclose on the 1978 double-wide. I think it might be worth about $5,000 if you could find someone to buy it”;
- Servicer to Outsourcer: “It doesn’t appear that a title policy was ever requested, paid for or issued”;
- Asset Manager to REO Manager: “What were those clowns in foreclosure thinking when they foreclosed on this one?”
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