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

Question

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?

Chuck Dreison · Answer

@Chris Seveney that's very helpful. Thanks for your response, I appreciate hearing your experience.

Chris Seveney · Answer

@Chuck Dreison

I have seen them 90 days to 3 years

Where I see them more in on hard money loans as some already have interest prepaid

The 3 years were on 2nd position notes which were newly originated and down payment assistance

Chris Seveney · Answer

@Chuck Dreison

See it in participation agreements all the time. Also some lenders will offer this on newer originated loans.

It’s not common but I have seen it offered on occasion

If there is a higher default interest rate then I would consider it but if it’s the same rate as default I would not accept it

Brooks Cole · Answer

I found a company selling small notes on raw land ($10-$50k range) that they buy out of bankruptcy/tax sales. I have been trying to talk them into it, but they aren't really open to it. They don't do credit checks so the new notes closed are at 15%. They want to sell the notes at par (even ones closed 2 years ago at 8% vs 15% today) which makes it even harder for me to do without the put option, but my thoughts are that they already have the sales channel in place & have already sold that piece of land before, so it is overall a net gain if they sell it.

I hadnt considered the extra complexity & especially liquidity from their perspective & needing to account for it, so that is a good point. Maybe I could alter my proposal so that they never actually have to put up the cash, but instead just earn a fee for reselling for me.

With the put option, I am essentially acting more like a bank for them and freeing up capital that they now have tied up in these loans. Maybe I just need to come in at a higher dollar figure to make it worth it, I have been wanting to buy one or two notes to start with and get a feel for how much it would cost me to liquidate a property in the event of default.

Dan Deppen · Answer

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.

Chuck Dreison · Answer

@Dan Deppen your point about an expiration date is a good one. Perhaps if the note was newly originated a one-year option might make sense.

In essence, the option could serve as a bridge while the note seasons.

I agree with your thoughts on introducing a lot of complexity -- hashing out all the details might only make sense for a very high-dollar note.

@Chris Seveney that's helpful to hear you've seen it infrequently on newly originated notes. Do you recall if there was an expiration date on those, as Dan mentioned?

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

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