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PORTFOLIO TRANSACTIONS Buying & Selling Portfolio's of Mortgage Loans
(and Owned Real Estate)
Alan Lascher
EXECUTIVE SUMMARY
Buying and Selling Portfolios of Mortgage Loans reached its zenith when the
Resolution Trust Corporation, charged by Congress with the task of cleaning up the
mortgage loan mess left behind by the savings bank industry, decided to tackle the
problem by auctioning off troubled bank loan portfolios en masse. The practice of selling
pools of loan assets spread to banks, insurance companies and other traditional lenders as
a means of clearing out their own portfolios from time to time, and, of course, is a major
part of the practice of securitization transactions.
This paper addresses the WHAT, WHERE, HOW, WHEN and WHY of Portfolio
Sales and Acquisitions, and sets forth some of the pitfalls to watch out for and issues to
be dealt with.
DISCUSSION
I. Buying and Selling Loans and Owned Real Estate.
A. Why do entities buy and sell loans, rather than simply making new loans
themselves? For several reasons:
1. To make money, as a business, as if they made the loans themselves
(earn interest, etc.). These entities pay the originator of the loan for the loan (plus, often,
an origination fee) and do not need to do all the leg work involved in originating loans
themselves.
2. To free up money to lend again, for fee making purposes.
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3. To take advantage of mortgage market dislocation, for example, the
RTC take over of banks; the collapse of the Asian Capital Markets, creating a "no loan"
atmosphere here among certain investment bank lenders, or as interest rates change, to
take advantage of changing loan values.
4. To create securitizable or syndicatable pools of sufficient size (the
entity often needs to acquire third party loans to own enough to make a workable pool);
and finally,
5. To "work" the loans or owned real estate as assets (i.e., either assist the
borrower in the recovery of its asset by doing a "workout", or foreclose and "work" the
asset itself and then sell, or simply selling it back to the borrower at a lesser discount than
it paid to acquire the loan.)
B. What is bought and sold? Loans and owned real estate of all shapes and sizes,
for all of the purposes mentioned above. This includes good loans, bad loans, good
properties, bad properties, environmentally tainted properties, etc. If you put enough bad
"assets" together, and create "tranches" of investment interest, you can always find a
buyer for the "top" tranches. However, in order to be able to acquire a portfolio, the
Purchaser needs to do two things:
1. It needs to learn about the assets in the portfolio being purchased, and
2. It needs to determine the price its willing to pay, based on what is
learned.
C. How does the Purchaser do that? There are two ways the Purchaser can
acquire enough information to make an intelligent determination of a possible purchase
price. They include:
1. Conducting a significant amount of due diligence with respect to the
pool of assets to be acquired; or
2. Entering into a purchase agreement that includes representations and
warranties covering at least the minimum information necessary to formulate a value and
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risk profile for the asset pool. Best yet is to get a combination of both, since certain
information (i.e. outstanding balances) is not obtainable simply by doing due diligence.
D. Which should the Purchaser rely upon, if given a choice? It depends on the
nature of the portfolio, as well as the financial strength, staying power and willingness of
the Purchaser to make and stand behind the representations and warranties. Generally
speaking, if the loans are good loans the Purchaser can rely more on the representations
and warranties; on the other hand, if they are bad loans the Purchaser is probably better
off relying more on due diligence, and filling in the gaps with representations and
warranties.
II. Due Diligence
In all cases, doing due diligence, although time consuming and very
costly, yields much greater information about the asset, and will produce a better
understanding of the two things the Purchaser really needs to know: Is there anything in
the legal file which would affect either: a) the ability of the lender to realize on the
collateral in a timely fashion in the event of a default; or b) the value of the asset, once
the lender forecloses.. These two items have a significant affect on determining the
purchase price a Purchaser would be willing to pay since any variation in either has a
direct affect on the IRR, or rate of return, the purchasing entity expects to realize on the
portfolio.
A. Diligence Checklist - The use of a due diligence checklist is a must. Since we
are always dealing with lots of assets, we, of necessity, need to use lots of attorney
reviewers, and they need a uniform guide as to what they should be looking for. Each
transaction requires its own checklist, since each group of assets have different basic
properties. The checklist must be designed to (1) produce uniform results from different
reviewers (so that the business people using the information for pricing purposes can
understand what is meant), and (2) must answer the two questions set forth in Section II
above.
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B. What happens to information collected? It is used to determine the value that
the client's underwriters (i.e., the business people who decide how much the portfolio is
worth) will put on each individual asset, as well as what risk factors are attendant to each
asset, and the likelihood of such risk having an effect; then aggregating the individual
values to determine a Portfolio value. But the due diligence information alone is not
enough. Certain information can only be obtained through the Purchase Agreement, and
the representations and warranties contained therein; so knowledge of what the Purchase
Agreement contains is important in determining the Portfolio value.
III. The Purchase Agreement.
Purchase Agreements for loan portfolio transactions have all the attributes
of purchase agreements for the acquisition or sale of real estate (price, down payment,
closing date, adjustments and representations and warranties); sometimes, the Purchase
Agreement is negotiated and sometimes it results from an auction process whereby the
Purchaser takes the Seller's form agreement, marks it up, fills in the purchase price and
submits it to the Seller.
A. Typical Representations & Warranties
- The type of representations and warranties that a Purchaser obtains in
portfolio transactions varies depending upon the deal; the extent of the
representations and warranties can be full blown, on a par with what
you would expect to receive in a single asset deal, or the Purchaser can
get something less than full blown representations, in which case the
added risk will cause application of a discount factor to the purchase
price. (For example, we saw a 50% discount in RTC deals where the
government was unwilling or unable to provide significant
representations). In determining the purchase price and whether (and
to what extent) to apply a discount factor, the Purchaser must also
consider whether or not the Seller has the financial wherewithal, and
willingness, to back up the representations and warranties. This
became very clear in the days of the RTC, when its avowed purpose
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was to go out of existence as quickly as possible! One had to question
the long term viability of representations and warranties under those
circumstances.
Typical representations and warranties include the following:
1. Representations and warranties as to the Seller organization. These
would include (a) that the transaction was duly authorized; (b) that there is no conflict
with existing agreements; (c) that no litigation is threatened or pending with respect to the
Seller, the Portfolio or the Transaction, except as disclosed; (d) that the loans were made
by an entity that was qualified to make and/or hold the loans ; and (e) that no consents
from governmental agencies or others are required.
2. Representations and warranties as to loans and loan documents.
These would include (a) that all of the loan documents are disclosed, (b) that Seller has
provided true, complete copies thereof, and that there are no undisclosed modifications;
(c) that the information contained in the loan schedule (i.e., loan amount, rate, lien
priority, maturity date, extension rights, type of property, recourse or not, additional
collateral, guarantees) is accurate; (d) that there are in the file a current clean Phase I
environmental report and engineer's report with respect to each mortgaged property or
real property; (e) that Seller is sole owner of the entire loan; there have been no
assignments, pledges, participators or other outstanding interests not reflected therein; (f)
that the mortgage creates a valid security interest, creating the lien it purports to create in
each mortgaged property; (g) that there exists no defense by the maker of the Note to the
payment thereof; (h) as to the status of the Loan (i.e., not in default beyond applicable
cure periods); (i) that the Loan is enforceable in accordance with its terms; (j) that there is
no right on the part of the borrower to receive additional loan proceeds (i.e., the Loan has
been fully advanced) and (k) that no cross-collateralization exists with collateral outside
of the Portfolio.
3. Representations and warranties as to the mortgaged property. These
would include (a) that there is no pending, and to Seller's knowledge threatened,
condemnation of any of the mortgaged property; (b) that there is no pending and to
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Seller's knowledge threatened, litigation in respect of any of the mortgaged property; (c)
that there exists no violation of law with respect to any of the mortgaged property
(zoning, restrictive covenants); (d) that a valid and enforceable mortgagee title policy is
in effect or can be obtained with respect to each mortgaged property insuring that the lien
is a valid first (or second, as the case may be) mortgage lien, subject only to current
property tax liens, not yet due and payable, and to such other common matters that do not
interfere with benefits of the security provided by the mortgage; (e) that there exist no
mechanic's or environmental liens; (f) that there is in effect an existing flood insurance
policy, with respect to each mortgaged property located in a flood zone; (g) that each
mortgage obligates the mortgagor thereunder to carry appropriate (defined) casualty
insurance; and (h) that no structural defects exist with respect to any mortgaged property,
except as disclosed.
B. Negotiating Concepts for Representations and Warranties. This is very much
like negotiating the representations and warranties in a Purchase/Sale Agreement for a
single parcel of real estate. One can get the benefit of many more representations if one
limits the scope of recovery, or establishes "materiality" as a standard before one can
complain. In other words, one can get more in the way of representation and warranty
protection from the selling entity by making the penalty for breach less severe, or in other
ways more palatable. Some of the ways to accomplish that goal are as follows:
1. Material Adverse Effect - no breach of representation shall be deemed
to have occurred unless the breach itself has a material and adverse affect on the value of
each individual asset, or on the portfolio as a whole, depending upon the representation,
and the negotiation This comforts the Seller that it will not be "nickeled and dimed" to
death with lots of little, relatively meaningless, errors.
2. Limited Recourse - A Purchaser can give comfort to a Seller that its
liability can not exceed a certain agreed upon amount, or can limit the availability of
remedies to the 3 or 4 remedies referred to below, so as to permit the Seller not to be
concerned about open-ended liability.
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3. Bucket - The same comfort can be afforded if you create an agreed
upon threshold for pain that the Purchaser is willing to suffer, and provide that no remedy
is available for breaches unless the agreed upon threshold dollar amount of harm, either
per loan or per portfolio, has been reached.
4. Except as Disclosed -Sellers are often made comfortable by the
purchasing entity agreeing that it will live with anything that has been disclosed to it,
either in the Purchase/Sale Agreement itself, or the exhibits attached thereto, or in
documents made available for diligence review. In other words, there is to be no remedy
for Purchaser if a representation is breached so long as notice of the breach has been
either expressly given or could have been or should have been found in the loan file.
5. No Written Notice or Knowledge - Many selling entities, particularly
lending institutions, will not make representations as to matters of fact of which they
have no, or little, knowledge. By allowing the Lender to represent that it has no
knowledge of a specific fact, rather than that the fact itself does not exist, can at least get
you "half a loaf". It is easier for a Lender (i.e., Seller) to represent, for example, that it
has no knowledge of, and has not received written notice of, a breach by a tenant under a
lease affecting a mortgaged property, than to represent that such breach does not exist.
Since it does not own such property, it does not have direct, first hand knowledge about
it. The Purchaser relies on the probability that if this was an important lease, the Lender
is likely to get notice.
6. Remedies Available - As I referred to earlier, another way in which
selling entities become comfortable giving representations and warranties is to limit the
remedies which are available to the Purchasers if a breach of representations occurs.
a. Pre Closing Discovery - Broadly speaking, there is a simple
remedy that is available if the breach of representation is discovered prior to the closing,
and that is to kick the affected asset out of the transaction (and reduce the purchase price
by the value allocated to such asset), and, if enough assets are kicked out to reach an
agreed upon level, either party can often "kick out" of the entire deal. This presupposes
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that the parties can agree upon an allocated value for each asset which, in the aggregate,
adds up to the purchase price for the entire portfolio (not an easy task).
b. Post Closing Discovery - If, on the other hand, the breach is not
discovered until after closing, the remedies available are often a little bit broader and
more complex. Upon discovery, the Seller is usually given the choice to either (i)
repurchase the asset, (ii) reprice the asset, or (iii) cure the breach. If the Seller elects to
repurchase, the Seller repurchases that asset for the same pre-agreed allocated purchase
price, and the parties adjust that allocated price to reach a final repurchase price which
takes into account interest received by the Purchaser between closing and repurchase, as
well as monies outlayed by the Purchaser, and an interest factor on the original purchase
price held by Seller during that period, or (ii) to reprice, in which event the Seller and
Purchaser have to agree on a reduction in the purchase price sufficient to reflect the
reduced value of the asset as a result of the breach, taking into account the likelihood (or
lack thereof) that such damage will come into play in Purchaser's realization thereon (i.e.
the asset, as damaged, may still be valued well in excess of the debt it secures, so no
harm would be realized), or (iii) to cure, in which event the selling entity is given a
specified time period to effect a cure of the breach, failing which it must elect either (i) or
(ii) above.
7. Environmental - Due to the desire, or even insistence, of Lenders that
they never have to take title to a property prior to having an environmental study,
satisfactory to them, completed showing the presence of no (or less than a threshold
amount of) hazardous substances, the representatives and warranties, and the remedies
available for their breach, are different than for the other representations. The
representation itself is usually couched in the "contingent positive" [i.e. that a Phase I (or
Phase II where indicated) environmental report with respect to each mortgaged property
satisfying the above criteria could be obtained], and the Purchaser is given a specified
period of time to gain access to the mortgaged property, conduct such investigation and
testing and receive such report. If it gains access and obtains a report, the representation
is either true or breached, and if breached, the Purchaser is generally given an absolute
right to "kick out" the asset as provided above (no Purchaser is ever required to acquire a
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"sinkhole"). If, on the other hand, access is not so obtained, the Seller is generally given
the right to extend the representation and the time during which the Purchaser may gain
access and test, and the process keeps going (hopefully, the loan will be paid off prior to
the issue ever really having to be faced).
C. Typical Covenants - The Purchase/Sale Agreements contain all the usual
provisions normally contained in similar agreements for the purchase of real estate,
including covenants as to (a) title (both as to the loan and the underlying mortgaged
property, (b) maintenance thereof (both loan and property), and (c) adjustments, which
are different than real estate adjustments, as well as some which are peculiar to loan
portfolios, such as:
1. Obligations Between Contract and Closing - In a typical single asset
transaction, borrowers or tenants of leases affecting the mortgaged property are contacted
and asked to supply estoppel certificates and/or other information with respect to their
loan, lease or the property. In most of the portfolio transactions I have worked on, the
Purchaser is not allowed to have any contact with borrowers, nor any contact with the
properties or the tenants thereon prior to closing. In addition, the Seller's only obligation
is to "standstill" between contract and closing, which means that Seller can not modify or
extend the loans in any way.
2. Post Closing Obligations - As to post closing obligations of Seller,
there are usually none (other than to turn over monies received from borrowers or tenants
that were transferred to Purchaser. The Purchaser's only obligation is to not default under
any obligation for which Seller could be liable.
IV. Closing Documents & Mechanics.
The need for closing documents and the mechanics for closing are like any
other acquisition and/or loan closing, and require the delivery of the following:
A. Loan Title Policy/New Title Insurance - Often in connection with bad loan
portfolios we have found that the lien status of the loans may have been compromised by
actions taken by the lender; we therefore recommend getting a new loan title insurance
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policy. This insures against such intervening and perhaps inadvertent subordination of
the mortgage lien to intervening liens, and gives the portfolio a marketability it might not
otherwise have.
B. Assignments of Mortgage and UCC-3 Assignments - These are relatively
standard documents, just like those in single asset transactions.
C. Omnibus Assignments - These are needed since, when doing assignments of
volumes of loan transactions, one does not have the time to assign individually each and
every document, nor does one wish to risk missing something. The "omnibus"
assignment alleviate both issues.
D. Original Notes & Allonges - Obtaining all of the original notes, and all
allonges in the chain to the selling entity, is a must, if you wish to acquire foreclosable
documentation for each loan. If there are any notes or allonges (endorsements) missing
from the chain, the Purchaser must get then from the selling entity. A lost note affidavit
in a form approved by your title company (so that they insure collectability) in the state
where the mortgaged property is located, and an indemnity against loss (including loss
resulting from time delay) arising out of the lost document can be an acceptable
substitute.
E. Notices to Mortgagors - Once again, this is a must, since you want the
borrower to immediately start making payments to the purchasing entity.
F. Delivery of Loan Files - Delivery is complicated when you are transferring
150 to 200 or more assets at the same time. In order to accomplish this, we developed the
technique of having a representative of each of the selling entity, the purchasing entity,
and the title company get together, put all of the signed, sealed and dated closing
documents for each file in an individual redweld, and sealing it, then putting all the
sealed redwelds in cartons and sealing them (in separate piles for delivery to each
appropriate party at Closing). When the time comes, and the Closing occurs, all one
needs to do with the closing documents and files is push the appropriate sealed carton
across the table.
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V. Additional Documents for Lender Financing the Loan Purchase.
These transactions typically involve a third party, the lender. The lender
would get the following documents at closing, as well as additional documents depending
upon the particular transaction:
(1) Collateral Assignments of Mortgage Loan and UCC-3 Assignments;
(2) Opinion Letter as to due authority; (3) Pledge Agreement, pledging the Loans as
collateral; (4) Title Policy for Lender, insuring its interest in the underlying loan
transactions. All of the foregoing documents are generally in substantially the same form
as would be used in any single asset transaction where the collateral securing an
obligation is itself a mortgage loan..
