How often do you buy/sell debt with buyback options?

[Chuck Dreison]

I’ve been chatting with a fund manager about our performing notes.

He asked a question I hadn’t heard before...

Would we be willing to buy any loans back if the borrower goes 90 days delinquent?

Typically, when funds acquire loans, they assume delinquency/default risk in exchange for earning a yield on their investment.

Yet this would work differently – it’s a request to purchase debt alongside a corresponding put option/insurance policy.

From the buyer’s perspective, as long as the seller remains solvent, with sufficient liquidity for any exercised options, it’s a risk-free investment. Any delinquent loans are “put” back on the seller.

From the seller’s perspective, it requires managing the complexity and liquidity requirements of outstanding options.

To compensate for the transference of risk, notes with put options trade at a lower yield.

- Sellers receive payment for the loan and a premium for the option.

- Buyers earn a reduced yield but hold a valuable option.

Much in the same way that equity yields are reduced in up markets when bought with put options.

How often do you buy/sell debt with put options? Any interesting experiences?

[Dan Deppen]

I've heard of people selling loans with guarantees, but I haven't been involved with one myself, nor do I know anyone who exercised the option. Would the option also have an expiration date or last the life of the loan? Beyond the complexity of unwinding the transaction and reassigning it, you would also have to compensate for the payments received by the buyer before it went delinquent. Also, does the buyer need to exercise it right at 90 days? If I was the seller and they came back with a loan that was 18 months delinquent and vacant I would be pretty annoyed. It feels like there is an awful lot of complexity, but I'm interested to hear what experiences others have had.