One of the toughest things for perspective investors to wrap their minds around is understanding with sound reasoning, “Why Banks Sell Mortgage Notes To Investors.”

In today’s post, I will do my best to add some perspective to the banking industry, the business banks are in and why the opportunity to buy mortgage notes from banks exists in today’s market.

What’s really behind opportunists seeking to make sense of the delinquent mortgage market with a frame of reference that they already have is: “If buying delinquent mortgage notes are so profitable, why would banks sell them to me?”  It does not take a genius to devise the follow up question that potential investors are already asking themselves,

“If delinquent mortgage notes are such a great business, why don’t banks keep them, there should be no logical reason that banks sell good opportunities, since they are in the business to make money not give investors slam dunk investment opportunities……”

If the though above has ever entered your mind, today’s article is for you.  Before we jump in and talk about today’s market conditions, it is imperative to back up a little bit and get a broader perspective on historical events and how financial challenges have been worked out of the system in the past to get possible reasons why we are here today and where we go from here.

Here are the top 3 explanations I have heard from bankers directly and my contacts in the banking industry that make sense to me to answer the question of banks selling mortgage notes to investors:

1) Capital Adequacy Ratios (CAR) from FDIC Call Reports

Along with FDIC Insurance comes rules and along with rules comes reporting.  Regulators will come and shut down a bank when CAR is too low. CAR is really just a fancy acronym to explain the capital a bank has vs. what they have at risk on the street.  Here is the formula how a bank’s Capital Adequacy Ratio is calculated:

CAR = (Tier 1 Capital & Tier 2 Capital)/ Risk Weighted Assets

Risk weighted assets are loans on the street.  Top figure on CAR equation includes Loss Reserves.

Here is a link to FDIC Call Reports for member banks: http://www.fdic.gov/quicklinks/analysts.html

Banks are very Balance Sheet driven.  What this means is that the health of a bank’s balance sheet impacts the bank’s ability to operate by making loans and borrower money from Federal Reserve.  Insured Financial Institutions must file quarterly “Call Reports” with the FDIC which tell investors and anyone else interested in reading dry quantitative data how financially healthy is each reporting member bank.

Banks do not report details of individual loans on these Call Reports to FDIC, but they do give a snapshot of their overall health broken down by the five major types of real estate: Commercial, Multifamily, Construction, Residential, and Farmland.  There are also Loss Sharing Agreements in place, which enable bigger banks to assume losses (bad assets) of smaller banks in an acquisition.  FDIC protects agains bank losses.  Example is deposit accounts at banks that are “FDIC insured up to $250,000.”

Here is a high level overview of what information is reported on Call Report of Individual Bank:

i. 30-89 day loan loans, still accruing

ii. 90+ day late loans, still accruing

iii. Nonaccrual

iv. REO (OREO, really)

Because “nonaccrual” mans the bank no longer expects the loan to be repaid in accordance with original terms, action is imminent.  Regulators don’t like to see disproportionate nonaccrual left unattended.  Nonaccrual is really the tail end of non-performing.

Banks are driven by numbers, personal owners of distressed assets are driven by emotions.  At the end of the day, bankers are motivated by their balance sheet.  Bankers care about recovering as much as they can of what they’re owed on a loan (getting whole), and when it becomes impossible or unlikely the next priority is to minimize the impact of the sale on their balance sheet or improve their standing with regulators when applicable.

Loans in a banks undergo periodic review depending on the type of the loan; the trouble in the portfolio; the industry that the borrower is in; and a host of other factors.  Some loans will come under more scrutiny than others.  When a loan goes through a review the bank is going to use a scale to describe to what degree, if any, a particular loan is “criticized.”  This scale might go from 1 to 10, but essentially this is a way for a bank to determine the level of urgency.

Not all loans that are criticized are behind in their payments (late or non accrual). Some loans are criticized because the owners look like they are in trouble, maybe their business is doing well.  When a loan starts down the road of default, at smaller banks, it is often the loan officer who is responsible for reaching out to borrower.

In a small institution, the “workout” may stay with the lender but as they bank gets bigger they will have independent workout departments where the loan will be transferred.  In larger organizations, workout groups may be split into groups determined by loan size or type.

2) Delinquency Rates and Organizational Structure

Historical mortgage delinquency rates were about .5% up until 2008, and then spiked to over 5% after 2008 as you can see from chart below thanks to http://www.calculatedriskblog.com/

 

 

 

 

 

 

 

 

What this means, is that banks had to make a strategy within the span of a few months to deal with “troubled assets” that were 10x the operational levels of what they were used to dealing with on a historical average.  Banks could have choose to expand their workforce significantly to handle these mortgage loans that went from performing to non-performing or sell them to investors like SCL Capital and let us deal with the challenges they no longer could handle in house.

Banks are very well aware that there is profit margin in the work we do for the assets we buy from banks and frankly they don’t care that much as they make plenty of money in other ways.  We will see in # 3 below, it all comes down to their business model.  Here is a little more background of what happens “behind the curtains” at bank operations:

It is common for the bank to try to “work out” a loan before moving toward bolder collection efforts, much more common on commercial loan rather than residential loan.  Here are some ways that banks will attempt a workout:

A) Modify loan terms for a pre-defined period

B) Encourage the debtor to market and sell the asset

C) Encourage a refinance with another lender of a different type of loan

Failing success with one of the strategies above the workout offer will either: move toward foreclosure, move toward a sale of the loan, work toward a deed-in-lieu of foreclosure.  When a workout fails and the property isn’t sold at auction and the note isn’t sold the property is acquired and becomes bank owned (REO).

Banks may or may not sell individual or even pools of non-performing loans buy they will ALL sell REO.  They must in fact. Banks, generally speaking, have to liquidate REO within five years of acquiring it.  In most cases they’d like to do it a heck of a lot sooner.  REO costs money to market and maintain.  Taxes and other municipal fees and costs are just the beginning.

3) The Business of Banks

Banks are in the business of renting money in a safe and secure way.  Banks are not interested in risk or risky business propositions.  This is exactly whey they make collateralized loans or loans that are attached to some asset so that if they borrower can’t make payment for whatever reason, the bank can collect their money through the sale of the asset backing the loan.

Banks are focused on renting money at one rate from the Federal Reserve or retail depositers via checking and savings accounts and then lending money at higher rates through mortgages, business credit lines….Banks keep the “spread” of the difference between how much it cost them to borrow and what they lend to their clients.

If we accept the above as true, banks are not at all in the real estate business or collecting loan business.  Banks are in the money business- borrowing money low and  renting out money at a higher rate while transferring risk to borrowers at away from the bank themselves.

Thanks for reading the entire article, I know this was a little long, so please let me know if you have questions about anything I shared today,

Jeffrey Greco