- Challenges in Buying Distressed Mortgage Loans
- March 12, 2012 | Authors: Michael J. Feinman; Robyn Neff
- Law Firm: Blank Rome LLP - New York Office
The market for non-performing and underperforming mortgage loans has been increasingly active and the level of activity is likely to continue as banks and other institutional holders seek to unload illiquid assets and redeploy their capital.
Sales of distressed debt are typically at a discount. The discount pricing allows the sellers to press for a disposition with "no strings attached." If the sellers and their selling advisers are skillful, they can also create competition among prospective buyers and time pressure to act before the opportunity to get a bargain is lost. The upside of an opportunistic and discounted loan purchase can be attractive, but because of the potential downside risks-the risk of buying into someone else's nightmare (or a nightmare that someone else was not even aware of)-it is crucial for buyers to gather and evaluate as much information as possible about what is being offered for sale.
Buyers of distressed mortgage debt should be prepared for alternative post-acquisition scenarios: (i) they may be able to negotiate a repayment or refinancing with the borrower, perhaps with greater ability than the seller, both business-wise, given their lower investment, and emotionally, having not lived through the failed lender-borrower relationship since its inception; (ii) they can quickly, or quickly enough, become the owner of the mortgaged property, carrying through the foreclosure and other remedies provided for in the loan documents; or (iii) they can become bogged down in extended and expensive litigation with the borrower and its principals, and perhaps with other creditors of the borrower.
In an ideal situation, a buyer of distressed debt should be able to obtain and review an accurate and complete loan file, which will include information about the loan's performance since its inception, as well as information about the property securing the loan. The buyer wants information about the state of the borrower's defaults and the surrounding circumstances, as well as correspondence and enforcement action taken or threatened under the loan documents. Because the loan buyer may ultimately own the collateral, it should get as much and as current property-level due diligence as possible, including environmental and zoning analyses. The selling lender's due diligence may be workable, but it may also be stale, and the selling lender may have had no reason to update the information (and probably had little or no cooperation from the borrower side on this front). The seller representatives involved in the loan sale might provide much or all the documentation they have about the loan, but they may have little actual knowledge about the situation. Even if the loan is being sold by the same institution that originated it, the people that originated the loan may have long since moved on from the company. The loan may have been originated in more frothy times when underwriting and documentation practices were much looser. In addition, the "loan sale" personnel are likely to be separate from the "loan origination" and even the "loan workout and recovery" people. The loan sale people are charged with quick and complete disposition (move this stuff out of here and quickly). The result of this institutional dynamic is that what is made available to a buyer may be a "data dump" which includes whatever may be on hand, rather than an organized and complete loan file.
It is crucial, then, that a buyer thoroughly examine the documents in the loan file with a careful and critical eye. It should confirm that it has all documents and materials to which it sees references, develop a list for the seller of missing items, and elicit any information implied by the documentation. No matter how little a seller is willing to represent, review of the documents will allow a buyer to determine essential information, including the payments to which the lender is entitled, any lender rights (and perhaps obligations) to advance funds to fund particular payments or to cure any conditions. In evaluating its rights and remedies the buyer should supplement its file review with a current title search, as well as judgment, lien and litigation searches relating to the borrower and any guarantors.
As with any mortgage loan, analysis of title is crucial to a loan buyer. It is dangerous to presume that the selling lender did an analysis and closed, so the exceptions in the seller lender's title policy are acceptable. That might be true, but it also might not be. A loan purchase considered recently involved a mortgage on a property, which was encumbered by a government regulatory agreement that prohibited mortgages (including the mortgage being purchased). The selling lender had closed on the loan, with the regulatory agreement as a "Schedule B Exception" to its title policy. Was this an oversight? A conscious acceptance of risk? Who knows, but the point is that the buyer, absent a careful review, might have unknowingly acquired seriously damaged goods.
Despite the "as-is, where-is, no strings attached" backdrop, a buyer should demand certain loan-related seller representations in its purchase contract, no matter how reluctant the seller is to warrant anything about the loan. There are matters that are, or should be, known to the seller, that no amount of due diligence can uncover. These representations include a seller representation that it is the sole legal and beneficial owner of the loan, and has not sold, pledged or otherwise transferred its interest in the loan. The seller should represent that all of the core loan documents (notes, mortgages, loan agreements, guaranties, as well as any litigation pleadings) are included in the loan file, the outstanding loan balance (which the seller may seek to base solely on the seller's records), that it has not released any of the parties, consented to any transfers, and that it has provided (or included in the loan file) all written notices of default given or received. A buyer should ask a seller to represent that the loan file is complete and accurate, but sellers may be unwilling to make such a statement particularly if the people responsible for administering the loan are not involved in the loan sale process. A seller will often state that whatever representations it makes are deemed automatically modified to the extent that the actual loan file contains conflicting information. Unless this automatic modification is limited (for example to selected representations rather than all representations), it underscores the burden on the buyer to conduct a thorough review of the all materials that are made available to it.
The loan sale agreement will address survival of representations and may provide specific mechanisms for addressing claimed defaults and effectuating remedies (such as a buyback of the loan under specific circumstances). The loan sale agreement will also contain detailed covenants and closing deliveries, which are beyond the scope of this article.
Although certain loan-related representations are fair and advisable, a buyer of a distressed mortgage loan may decide to forego some or all representations, if competition for a deal is strong, or the buyer otherwise lacks leverage and the price is sufficiently attractive. The buyer ultimately must rely on its own hard work in understanding the asset it is acquiring. However the drama plays out, buyers of distressed mortgages must use sharp eyes and sharp pencils to decide whether a loan is discounted adequately to address the various risks that the buyer will be taking.