CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

This year’s panelists appear ready to discuss the many different facets of the REO-to-Rental market and the opportunities and potential pitfalls related to owning and investing in this portion of the market. Some highlights will surely include the panels on Securitizing Rental Streams and Equity and Debt Financing, as well as the panels on Note-to-Rental and Pre-Foreclosure Buying.

As this asset class continues to change and evolve with the broader real estate market, so do the strategies on how to profit from owning REO-to-Rental properties, and this Forum is sure to advance the dialogue surrounding this asset class and those strategies. Dechert will continue to blog from the conference and we hope to see many of you there.

By: Ralph Mazzeo, Matt Clark and David Pildis
 

The report highlighted four specific areas of concern present in equity-pledge structures:

● Severity of Substantial Consolidation: The lack of individual mortgage liens presents significant risks to investors in the case of substantive consolidation of the property-owning SPV with its Sponsor, as investors would be forced to compete with all of the bankruptcy estate’s other creditors without the benefits afforded to a secured creditor.

● Increased Likelihood of Legal Challenge: A corollary to the first point, the lack of first priority liens on the underlying assets would incentivize creditors of the estate to push for substantive consolidation.

● Unauthorized Sales of Properties: The lack of individual mortgages leaves investors open to property-level risks ordinarily covered by mortgages. For instance, in the event of an unauthorized sale of an underlying property, the investors would still enjoy the protection of the mortgage lien, which would “travel” with the property. Not so in the equity-pledge structure, as investors would need to rely on suing on covenant defaults and would not have direct access to the transferred properties as collateral.

● Additional Liens: The lack of individual mortgages leaves investors open to additional liens, including additional mortgage liens and mechanics’ liens. These liens are ordinarily primed by a first mortgage. In the equity-pledge structure, these liens would need to be satisfied by the foreclosing trust.

For more information on REO-To-Rental structures, please see our prior blog posts here and here, and Dechert OnPoint Updates here and here.

By: Matthew Clark
 

The Potter Trophy: “Qualified Residential Mortgages”

Potter Stewart famously refused to define obscenity in Jacobellis v. Ohio.  “But I know it when I see it”.  Perhaps that’s how we’re fated to look at the QRM. It’s eighteen months after the end of the initial comment period, and thousands of comments were made.  And we’ve heard?  Crickets.  But now, we hear we may be close to a pronouncement of the scope of the QRM exemption to the Dodd Frank risk-retention rules.  This is important.  Securitizing a pool of QRMs is the only way to avoid the notorious and economically inefficient 5% retention requirement imposed upon the capital markets in a misguided effort to improve underwriting.  During last month’s ABS East Conference, keynote speaker Lewis Ranieri announced (unexpectedly) that the criteria for QRM’s could be finalized by the end of November.  Huh!  It’s the end of November.  Nothing yet.  And by the way, we have heard officials say in various public forums that they hate QRM and would prefer almost nothing to qualify, so let’s hit pause on declaring good news.  I’m afraid I really will know it (for what it is) when I see it.

The Lunch Pail Award: REO-to-Rental

This award recognizes really hard ways to make money.  Owning bunches of single family rentals for income and eventual appreciation strikes us as particularly hard duty.  Nonetheless, the conversion of distressed or foreclosed single family homes into rental properties on a mass scale is one of 2012’s most discussed real estate investment ideas, with the FHFA’s Real Estate Owned Initiative already offering product in bulk sales and major institutions stepping up to finance the buyers.  Investors are still trying to determine if securitization will develop into a viable exit, and although many Rating Agencies have offered initial indication of how they view the segment, none have published official criteria.  Will REO-to-Rental strategies serve as an important way to stabilize neighborhoods and infuse private capital into the housing market?  Maybe.  Will it be a hard way to make a buck?  For sure.

Rookie of the Year: The Fiscal Cliff

The “Fiscal Cliff” succeeds last year’s “Eurozone Crisis” as the financial catastrophe of the moment.  Bernake’s felicitous description of this looming disaster captures what happens when the State increases payroll taxes, raises income taxes (a lot) on businesses and individuals, introduces new Obama-care taxes, ends Bush-era tax cuts, slashes spending on thousands of government programs while fleecing anyone who may have been missed with increases in the AMT.  Are we going over the cliff?  The stock market says "no" one day and "yes" the next.  Perhaps our elected leaders, with the flittering attention span of, well, elected leaders, can’t get their collective brain around the fact that this has to be fixed now and not on December 31 (or February 28th!) because if they delay, the ride up the precipice may be almost as bad as the ride over it.  Wanna bet we won’t go over in any event?

Plymouth Rock Award: The Electorate of the Commonwealth of Massachusetts

In a rare Election Day triple witching, Massachusetts voters overwhelmingly supported the re-election of President Obama, replaced centrist Senator Scott Brown with the decidedly left-of-center Elizabeth Warren and defeated a referendum permitting physician-assisted suicide, leaving Bay State republicans demoralized, depressed and devoid of options.

James Madison Constitution Award: California Municipalities’ Condemnation of Underwater Mortgages

In an attempt to stimulate local economies and avoid the inevitable blight of mass foreclosure, Golden State municipalities this year considered a controversial eminent domain plan whereby underwater residential mortgage loans held in private-label securitizations would be seized, refinanced or restructured and sold to third-party investors.  As we wrote this summer, the plan promised to garner legal challenge, with even the FHFA expressing “significant concerns about the use of eminent domain to revise existing financial contracts”.  We have a social problem, and it’s serious.  But there are some things that pesky Constitution just won’t let governments do, and that’s not so bad now, is it?

Comeback Player of the Year: Financial Innovation

2012 saw the successful issuance of several highly structured deals, including the first U.S. liquidating trust vehicle successfully securitized in the United States since the 1990s.  As we noted in May, the liquidating vehicle deal – involving a plan to orderly resolve a pool of poorly (or non-) performing loans and REO assets – was successfully closed and sold, while other high-profile transactions merged CMBS and CLO technology to securitize bridge and unstabilized loans while addressing the sponsor’s need for flexibility with the investors’ need for stability.  Financial complexity – the scapegoat for the credit failure of the last half of last decade – may finally cease to be a dirty word.  That would be good.  Hard problems sometimes need complex solutions.  If the Luddites had its right, we’d all be knitting sweaters and mucking barns.

The Midnight in Paris Award: The EU 

The EU continues to flounder gently but inevitably towards economic ruination.  Days, years, months go by without much fundamentally changing.  Debt won’t fix debt.  Countries and regions in deep depression need to control monetary policy and depreciate their currency.  The modern European welfare state is exhausted by the reality that they are running out of other people’s money (Mrs. Thatcher has always been right).  It seems the economic political class closes their eyes regularly and wakes up in a world where none of that is true.  All is well.  Then the markets nudge the politicos to wakefulness, they stare at the crisis, have a moment of panic, hold a summit and back to Midnight in Paris where all is swell and beautiful.  Sweet movie.  Lousy way to run a continent.

The Alex Haig I’m in Charge Award: The Consumer Financial Protection Bureau

The CPFB concluded that their mandate of protecting consumers confers a right and moral imperative to regulate almost anything and everything.  While the financial marketplace worries about capital formation and getting back to business, the CPFB is stomping on the rule making authority of half a dozen other agencies and issuing tracts and rules conflicting with the rule making authority of many other financial sector agencies.  At best, we end up with expensive duplicate regulatory regimes.  At worst, we get conflicting regulatory regimes.  Here again, we see another regulatory agency which conflates what works on the chalkboard with what works in the real world.  For example, the CPFB’s efforts to simplify mortgage disclosure is creating a dog’s breakfast of complicated arcane mechanistic rules and procedures which reduces capital flow to the consumers that the CPFB had set out to protect.  It’s not hard to see that very little changes.

The Willy Sutton Award for Robbing the Banks Because, as Mr. Sutton Famously Said, that’s Where the Money is: Governmental Entities that Filed Suit Against Major Banks

During the years running up to the credit crisis, there was sloppiness, blindness, indifference to risk and, it turns out, in some cases, truly bad behavior in the residential mortgage lending business.  But adding to the tsunami of private suits, from sea to shining sea, governmental entities have decided that the major banks are a piggy bank of money which can be tapped through lawsuits.  Typically, the conceit is that the money will be used to right those wrongs and help individual consumers but, oddly enough, it seems that much of the money is flowing into the general coffers of the states and other governmental entities and gets spent like any other tax dollar.  Stop.  It is wrong, it is disingenuous, and it is hurting the banks at a time when the health of the banking system is critical to the restoration of the markets.

Caligula’s Horse Award: Wells Fargo Bank NA v. Cherryland Mall Limited Partnership

An event completely devoid of the exercise of common sense.  Presumably the good people of Rome some 2,000 years ago were a bit put off when Caligula made his horse a senator (one might be tempted to suggest our recent elections may have partially accomplished that goal in several instances).  Here, I’m talking about the Cherryland case.  It was late last December that the Court of Appeals of Michigan issued a widely-discussed decision in Wells Fargo Bank NA v. Cherryland Mall Limited Partnership – holding a guarantor liable under a non-recourse carve-out for a borrower’s failure to remain solvent.  It’s a non-recourse loan, people.  The lender knew that, the borrower knew that.  Bad drafting allowed a crafty trial lawyer to argue that even though the parties said the loan was non-recourse, it was only non-recourse as long as the borrower could pay.  Like in the novel Catch 22, you can only see the Major when he is not there.  Do we really need decisions like this?  Well, at least it caused the industry to scurry off and tighten the language of guarantees but, come on.

And so another year ends with the full measure of silliness and inanity we expect.  Traditions are wonderful.

By: Rick Jones, Matthew Clark & The CrunchedCredit Team
 

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...

By: Ralph Mazzeo

Over the past few months, an inter-disciplinary group of Dechert finance, real estate, regulatory, banking, securitization and financial services attorneys have had several conversations with clients discussing how these deals will work.  This week, I co-authored a brief article together with my partners Patrick Dolan, Mac Dorris, Bob Ledig, Ralph Mazzeo, Tom Vartanian, Jay Zagoren and Gordon Miller that highlights an innovative program initiated by the FHFA, designed to convert thousands of single family REO to rental properties.  This article focuses primarily on the issues faced by investors, and provides a detailed explanation of the FHFA’s plan and recent events related to the initiative.

Now if only we could convince this year’s crop of college graduates to rent an apartment instead of returning home … 

Click here to access the full Dechert OnPoint.

By:  Matthew Clark

It was clear from a Tuesday afternoon panel that the waves of civil litigation in the RMBS industry will continue to crash on the shores of every major financial institution.  Did you actually think that the statute of limitations would prevent plaintiffs from pursuing claims?  Unfortunately, in an effort to prove that the government can perform any task better than private actors, President Obama announced at his State of the Union address (televised on the last night of the Conference) that he was forming a new financial crimes unit to pursue mortgage securities fraud during the financial crisis.  Wells notices are flying out of D.C. at a rate only surpassed by the dollars coming off the printing presses at the U.S. Mint.  It’s ironic that this new focus of investigation is kicking off at the same time that a $25 billion agreement was reached with five large mortgage banks to settle federal and state investigations in 49 states into alleged foreclosure abuses.  (Oklahoma reached its own settlement with the banks on Thursday.)  Note also that the “settlement” doesn’t prevent individual borrowers from continuing to bring claims.  Some of my litigation partners and I plan to host a seminar in our NY office this spring to offer our clients and friends much more detail on all of these developments - I’ll inform you of the particulars of that event in a subsequent blog. 

But the other big topic that continues to garner a lot of attention is how to effectively manage the liquidation of the huge inventory of foreclosed homes on the balance sheets of the banks and the GSEs.  Analysts estimate that there are 500,000 REOs on the balance sheets of the GSEs and private lenders, and the number is obviously expected to increase as foreclosures continue at a high rate.  How then do banks liquidate these properties without having to sell them at fire sale prices and without putting downward pressure on a housing market that is desperately trying to plateau and inch upward in many markets?  With demand for rentals rising in many markets, there is a lot of buzz among private equity investors with the idea of buying up bundles of REO, renting them out for 1-5 years, and then flipping those properties when home values recover.  And the lenders sitting on a huge inventory should welcome this new investment strategy as such investors should drive up the bids for REO.  But the key to all of this happening is on what terms can investors get financing for the bundle of REOs they intend to buy up.  I think this discussion will dominate the residential market for the next year and may well be the key to a meaningful economic recovery.  Stay tuned for more information on a Dechert sponsored webinar on this topic.

By: Ralph Mazzeo