America loves a good second act.
This is especially true when the first act was depressing, or an individual suffered unfairly, only to come out on top during the process of rebirth.
Usually, a second act has to do with a person who’s spent a lifetime doing one thing and has now found an opportunity or a calling to pursue something he or she is passionate about, or can achieve great success doing. But one of the least-noticed second acts in America today isn’t about an individual — or even about people, at least not directly. It’s about mortgage loans, specifically re-performing loans. And it’s a pretty amazing story.
Act One: The Great Recession
The housing boom of the early 2000s, you may recall, was followed immediately — and rather unceremoniously — by what may have been the most rapid and most severe housing bust in U.S. history. During the boom, homeownership rates, fueled by reckless lending, approached 70 percent. The number of homes sold peaked at over 7.2 million existing home sales and nearly 1.4 million new home sales in 2005. Home prices soared — the median existing home price peaked at $230,400 in July of 2006, up 57 percent from July of 2000 — and new home prices peaked at $250,400 in October of the same year. A home was no longer just a place to park your car — increasingly, it was a place to park your money, and everyone wanted to become a real estate investor.
Unfortunately, the real estate boom turned out to be a house of cards. Far too many unqualified borrowers purchased overvalued homes with loans that turned out to be ticking time bombs. What happened next — in retrospect — was unsurprising, but still historically unprecedented: the largest wave of foreclosure activity ever in the U.S. housing market.
As chronicled by ATTOM Data Solutions (known at the time as RealtyTrac), foreclosure activity soared. Historically, about 1 percent of loans in a given year are in some stage of foreclosure; another 4 percent are delinquent, but not yet in foreclosure. At the peak of the crisis, about 4 percent of loans were in foreclosure and between 11 and 12 percent were delinquent. This, remember, at a time when the number of homeowners — and the number of active mortgages — was at an all-time high. So what ultimately happened to all of these loans?
According to a report from Hope Now, nearly 5.3 million of those loans were ultimately foreclosed on between 2009 and 2016, with the peak happening in 2010, when there were almost 1.1 million foreclosure sales.1 These numbers, and the financial and human damage they caused, were widely reported. Less-widely reported was what happened to millions of other loans that had become distressed: they were modified, in an attempt to help borrowers retain homeownership.
Second Act: From Non-Performing to Re-Performing
While the number of foreclosures was staggering, the number of foreclosures prevented by loan modification programs was equally remarkable. Between the second half of 2007 and 2017, over 8.4 million permanent loan modifications were completed, either through the government’s Making Homes Affordable Program (HAMP) or mortgage servicers’ proprietary modifications. In addition, lenders provided borrowers with other workout plans — repayment plans, payment reductions, forbearance programs, etc. — on another 16.4 million loans.
If this were a Hollywood screenplay, we could wish our actors a “happily ever after” and exit the movie theater. Unfortunately, many of the borrowers who held these modified and re-worked loans subsequently became delinquent again, and some defaulted, and fell back into foreclosure. This created a large number of what the industry refers to as non-performing loans (NPLs). As the U.S. economy slowly recovered from the Great Recession, investors began to purchase portfolios of these NPLs, mostly from large financial institutions or government agencies looking to get the loans off their books.
These loans were purchased at a discount, and represented an attractive investment opportunity for companies who knew how to manage them. While a few of these investors bought NPLs with plans to quickly execute foreclosures and either sell off or rent out the properties attached to the loans, others found a more lucrative approach that constituted a win/win scenario for the investor and the delinquent borrower.
It turns out that in many cases, the best outcome is to turn an NPL into an RPL — a re-performing loan.
Many of the companies who bought NPLs (including my employer, Carrington) have mortgage servicing operations that specialize in helping borrowers with financial challenges. They share a mutual goal with the customer: to keep the borrower in the home. While this provides the borrower with another chance at homeownership, it also provides the investor with multiple opportunities for return — holding the loan in its portfolio and collecting interest over time, or packaging and reselling the loan, either to investors who buy whole loans, or as part of a securitized transaction.
To help ensure success, NPL purchasers very often offer principal balance reduction to borrowers who successfully make on-time payments during a trial period. Companies who are successful with this approach often help as many as two-thirds of these borrowers avoid foreclosure — quite an outcome, considering that typically almost 100 percent of the loans in an NPL pool are already in foreclosure when they’re purchased by the investor.
A decade after the bankruptcy of Lehman Brothers marked the unofficial beginning of the financial market meltdown, the pipeline of NPLs is finally drying up — unsurprising, since delinquency levels are back to normal levels, and the number of loans in the foreclosure process is roughly a third lower than normal. Many of the formerly non-performing loans are now performing nicely, and RPLs are becoming a hot commodity in the institutional investment community. By Carrington’s estimation, RPL purchases now surpass NPLs.
In 2017 there were roughly $30 billion in RPL sales compared to $12 billion in NPL sales, and the trend has continued into 2018, with first quarter sales leaning towards RPLs by a margin of about $8 billion vs. $5 billion for NPLs.
RPL buyers tend to be different types of investors than NPL buyers — they have different (longer) time horizons for their investments and different yield profiles. And the risk/reward ratio tends to also differ, which means “safer” loans like RPLs typically don’t sell at the kind of discounts that characterized NPL sales. In fact, seasoned RPLs (clean payment records for 24+ months) with high equity often sell at par or even above. But the availability of these loans — both as whole loans and in securities — has attracted interest from a variety of funds looking for longer-term investment opportunities.
The presence of these RPLs is bringing back institutional investors to the mortgage securities market, perhaps an early sign that private capital will begin to lessen the industry’s dependence on the overwhelming amount of government funding that’s poured into mortgages over the past 10 years. And every RPL represents a borrower who was in some sort of financial distress but was able to correct course and maintain homeownership. In addition to the obvious benefit to these borrowers, RPLs kept hundreds of thousands of properties from flooding the market as distressed homes (the long-rumored “shadow inventory”), which would have further depressed home prices, and prolonged an already interminably long recovery in the housing market.