In case of a recession, how will my notes be affected?

[Jim Workman]

It has been almost 10 yrs since the last recession started.  Many of us have not been through a downturn.  Can some more experienced members tell us what to expect if we own notes and give suggestions on recession-proofing our investments?

Performing Firsts:

Performing Seconds:

Non-performing Firsts:

Non-performing Seconds:

[Dion DePaoli]

Great topic to start and frankly, it is probably time we embark on the discussion. I think you will find that not many note investors around these boards were affiliated with note investing during the last recession. So that may act as a barrier to some level of participation. On top of that, I would suggest the common narrative of the leading causes of the last recession are mostly barstool banter. As such we should look at what happened in the last recession and from there attempt to extract what may be important to consider when understanding a portfolio in today's time. Brace yourself, I am going to put BP servers on over drive here.

Let's first start by narrowing the vintage of mortgages which contributed to the crash. The notable years of originations range from 2003 up to 2007. We leave off 2008 forward since the crash itself really started in 2006, became known in 2007 and was at large in 2008. We start off in 2003 as that is when performance nudged past typical default rates and took us through the crash. Oddly enough, 2000 vintage loans had higher default rates in near term than those of 2001, 2002 and 2003. Within 60 months of origination 5.6% of 2000 originations had defaulted. However, the other 3 years had rates less than 3%. We will, for the sake of this discussion, simply set that aside as an enigma and move to the vintage years I mentioned.

So as we just learned, running up to the vintage of concern we had very manageable default rates. 2003 also benchmarks one of the last year where more mainstream mortgage products dominated the market. As we started to progress through 2003 mortgage products started to include exotic features away from standard fully amortizing loans. Not to say that products such as interest only had not previously existed but rather the share of those products in the market started to grow rapidly. To that extent, there happened to follow an erosion borrower equity by both down payment and pay down through periodic payments (fully amortizing). In 2003 & 2004 we still made 90% CLTV (just under actually) loans, however those loans required full amortization. As we progressed through the years we pushed the CLTV envelope to a point where in 2007 median CLTV was closer to 98% than 90%.

To help understand that impact for those unfamiliar, a loan in 2003 at median 90% CLTV would be closer to 70% CLTV in 2007. Clearly insulating those loans from the market declines in RE value in 2007-2008. Adversely, the worst performing vintage in terms of default, which is 2006, would go from a median CLTV of around 95% to 110% after 4 years. So if you were to graph the median CLTV of each vintage year over time you would see 2003 & 2004 arc downward toward a lower CLTV over time thanks to paying down principal thus earning equity. While 2006 & 2007 would arc upward increasing the median CLTV over time. As one might be able to extrapolate, 2007 median CLTV exceeded 100% within a year.

This data suggests that the programs deployed in the market greatly influenced the erosion of equity which was then further exaggerated by the decline in RE value to follow. Programs such as interest only and negative amortization rose in popularity and frequency which put the upward trend on steroids.

This is then the last place where the typical narrative will fit into the actual data. That narrative being, sub-prime borrowers caused the crash, per se. To put it simply. In fact, in stark contrast to that idea, the 2003-2004 vintage of sub-prime loans is actually the best performing segment of loans within the 2003 to 2007 vintages with a default rate below 6%. In the same timeframe from origination 5% of 2003 & 2004 loans defaulted whereas within a similar timeframe from origination the 2006-2007 default rate was 20%. For all intents and purposes, the borrower’s credit worthiness was relatively the same among the good and bad segments. The difference was in the program and the ability for the borrower to earn equity over time.

So the point of all that data conversation was indeed to cause us to pause on the idea that sub-prime borrowers were in fact the major culprit in the mortgage crash. The fact of the matter is, the same sub-prime borrower is successful in 2003 and unsuccessful in 2006. This idea points us to the more prevalent drive of default and thus value decline – lack of equity.

I won’t dive back into a bunch more data but as we progressed from 2006 forward defaults spread into conventional conforming loans. While there is some level of affinity to local market conditions such as employment and wage, those too have mostly been speculative whereby equity or lack thereof seems to account for almost 95% of all defaults across the entire spectrum of vintage.

If we accept this idea, we can then turn and look to the post-crash recovery and the actions taken which should drive us close to a point where we are now. Most loans in the US were originated for the purpose of securitization. Now, that said, most folks don’t fully understand what that means or what that market “actually” looks like. We understand there are loans that are securitized and loans held in portfolio and it probably ends right around there. Interestingly enough, there are two separate versions of securitized loans – public and private. Commonly we think Fannie Mae and Freddie Mac securities when the idea is mentioned. Those are indeed the major loan pool security makers. They are the “public” securities. Where public is a reference to the label of the issuer of the security. However, lesser known is there was and is a good sized private security market. Those would be securities issued by the private banks we all know such as Bank of America, Wells Fargo, Chase and you get the idea.

So to be clear, Bank of America can both originate and sell loans in to Fannie Mae which eventually get pooled into a security plus originate and pool those loans into a private security and sell the security itself. As long as there is a market consisting of investors who will buy into the private security those securities will be made. And therein lies some of the issue.

As we all know, Fannie, Freddie and Ginnie (FHA/VA) help define dominate underwriting guidelines. They are all also large entities which do not move quickly – which in the case of responding to market conditions can be seen as a good thing (conservative) or a bad thing (opportunity cost). In the same vintage years as we have been discussing in 2003 we have roughly an 80/20 split of the security RMBS market. (Residential Mortgage Back Security) Guess what happened in 2006…go ahead, you can probably predict it. 60/40. That's right, private label securities rose from 20% of the market to 40% of the market in around 3 years. Thus the public security market shrunk. Just as a tid bit of history, Fannie Mae was created with Ginnie Mae in 1938 to only buy FHA, VA and FmHA loans. In 1970, Fannie Mae began to purchase privately originated mortgages. Point is, in my opinion, while not perfect, they certainly had a lot of practice and over time developed prudent underwriting standards to protect the market including borrows and investors. In 2002 forward, we let the market share of private securities erode those standards. The above erosion of the median CLTV along with the exotic mortgage products are the constructs of that private security market. To that degree, the public entity underwriting guidelines ("conforming loans") were eventually seen as too restrictive and thus sub-prime and exotic mortgage products emerged and rose greatly in the market.

This is all important, in my opinion anyway, to those newbie investors who seek to buy the currently distressed loans at large because I don’t think most ACTUALLY understand who, where or how the loan they purchase or want to purchase came to be. What the driving force was of the origination and even worse – the servicing directives on those loans leading up to their purchase.

Most of what is circulating around for private investment is the private security driven market. NOT the public security driven market. That is important to understand as the incentives for modifications and delinquency and default treatments are grossly imbalanced between the two types of entities. Without getting into a tirade of details, private security driven mortgages loans ‘seemed’ to have preferred to preserve principal balance and lower rates as a response to market decline and borrower hardship opposed to their public counterpart which was given specific directives to reduce principal and consider lower rates through HARP and HAMP, etc.

So, now that we have come to current times, what can we expect and how can we take action to protect and preserve our capital as private investors picking up the pieces of the mortgage crash?

Well, as hopefully we learned above two simple lessons: (a) Equity is good for everyone and (b) avoid exotic and overly ambitious loans which do not afford the borrower full amortization and a clear and short term path to earn “real” equity.

I think (a) is pretty easy to understand but I fear it is often overlooked in practice. As a distressed loan buyer you want to give your borrower any equity you can spare. Think of it as their buy-in incentive. Even if it is a sliver. If you seek a reinstatement modification try and avoid modifications which come in at par or above par keeping the borrower in negative equity. Equally, in honorable mention because this is BP and we have seen them on the boards here – stay far away from Contract For Deeds or Land Contracts or any newly originated or modified loan which puts the borrower in negative equity. We as investors often consider our equity to investment but gloss over how to convert any of that into borrower equity. It’s not easy but bring it to top of mind and chances are you will see better reinstatement performance or long term performance from your loan investments.

There is a saying and I like it a lot – “pigs get fat and hogs get slaughtered”.

Now (b) probably has its issues with converting into actual practice. As such, I will share the magic that isn’t – after all, if you made it this far in this thesis you deserve something more than a simple door prize. When setting up treatments for your loans, mainly those which seek reinstatement be (a) realistic – if the borrower can’t afford to make payments do not act like they can. Low debt to income ratios are your friend. Additionally, (b) short term amortization is probably your commonly overlooked resource. We spend so much time trying to figure out how to buy a 30 year instrument we overlook that it is in fact a long term investment. When given a chance to treat a loan contemplate treating the loan with principal pass through. What I mean by that is, look to shorten amortization terms. Offer forbearance of principal only instead of interest only. Contemplate treating a loan so that it can rapidly earn equity and pay to zero over a shorter time. Now, notice how we are not bringing into the field of view balloons. Be cautious of creating a balloon event. Future credit markets may very well be tight, we can’t know for sure. Instead, take that discount you received and convert it to borrower capacity to earn equity. You can do this and not erode your yield. Shorten the term and raise the rate. Give adequate payment relief. To put it metaphorically speaking, people will try harder to make things work when they can see the end result in view, like paying to zero in 10 years instead of 22. You will likely be surprised how much better your loan performs and gains in value in the secondary as a result of such ideas being put into practice.

To speak to the non-performing loans of the market – there is no real secret here. Bid them correctly and set aside proper reserves to disposition the asset. Do not use DIL’s and Shorts as your primary disposition strategy. They are iterations but always plan to foreclose and anything short of that is simply benefit to you. If you can reinstate and the borrower is capable to reinstate, refer to the above. I do think there is more of an opportunity now than earlier post-crash to reinstate and if the market fades again borrowers who have earned equity will be more likely to work harder to keep it.

In regards to second liens, still not a personal fan. Do note the above CLTV median erosion put second liens in first loss. None of that changes. Personally I would never consider an asset without equity and even in second position with equity your position can be jeopardized if you are not careful. Cavet Emptor.

In regards to recession proofing your portfolio – I was fortunate enough to stumble through the crash minimizing the big red numbers in the funds I managed. I saw many funds come and go post-crash. Every second lien fund I knew has since gone out of business. The NPN only funds mostly failed with those surviving being born after 2012. The legacy costs of the assets were simply too much to capitalize. As such, I think having cash flow present in the portfolio is important.

In summary, I do think there is another adjustment coming our way. Some markets will be more affected than others. That said, loan level performance is exactly that, loan level performance. Putting forth good fundamentals in your loans with ensuring borrowers can earn equity; proper allocation of needed advances are set aside and try remaining objective with your loan treatments as opposed to forcing a loan to bend to your will help weather the storm.

I think more street level private investment helps turn around some of the previously blighted asset situations and areas. As such, stay nimble and opportunistic as an investor it is what sets you a part from your institutional competition. Good luck.