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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

    discov...