[COVID-19] Early Payment Defaults in Loan Sales

The COVID-19 pandemic has had far-reaching impacts for the real estate finance market.

As borrowers increasingly have trouble staying current with loan payments, lenders and brokers, as sellers (“Sellers”), with investors, as purchasers (“Purchasers”), under loan sale agreements will likely find that early payment default repurchase provisions included in such agreements are triggered with increased frequency.

What is Early Payment Default?

“Early Payment Default” is a term often used to refer to a mortgage loan that is more than ninety (90) days delinquent or into a default status in its first year. Early payment default is one of the strongest indicators of possible mortgage fraud. Most mortgage industry investors or loan Purchasers are very concerned with identifying early payment defaults and performing quality control checks to determine if mortgage fraud has occurred. As a result, under the terms of loan sale agreements, a contract provision may be included whereby the Seller is required to repurchase such loan or provide some other remedy upon the occurrence of an early payment default.

Repurchase Price Calculation/Repurpose Obligation

Purchasers under a loan sale agreement will oftentimes include a repurchase price calculation and a repurchase obligation triggered by a loan borrower’s failure to make one or more monthly debt service payments:

1. During the first twelve months of the loan term,
2. For a specified payment period following the closing of the underlying loan being purchased,
3. For a specified payment period following the closing of the loan sale agreement, and/or
4. Some other combination of the foregoing.

As the Seller, this creates a risk that the capital received following the closing of the loan sale agreement will remain at a risk of being returned until the aforementioned loan periods lapses. The repurchase obligations included in a loan sale agreement can vary widely based on the Purchaser’s level of sophistication. Since Sellers are oftentimes not well capitalized and therefore dependent on the proceeds of the sale of a loan to investors in order to continue originating loans to new borrowers, a triggered repurchase obligation can have drastic impacts on the Seller’s ability to continue operations. 

COVID-19 Poses a Risk to Borrower Defaults

The current economic climate created by the COVID-19 outbreak poses additional risks that the borrower under a loan will default. This is due, in part, to:

1. Increasing unemployment rate affecting a residential tenants’ ability to satisfy rent obligations for business-purpose loans secured by 1-4 unit properties and multifamily properties,
2. Increased business closures affecting commercial tenants’ ability to satisfy rent obligations for commercial properties, and
3. Decreased liquidity available to promissory note borrowers as a result of the foregoing.

Accordingly, it is critical for Sellers to understand the extent and scope of repurchase obligations included in a loan sale agreement and to limit or eliminate early payment default repurchase obligations whenever possible.

Mitigating Repurchase Obligations

There are several ways for Sellers to mitigate the repurchase obligations contained in a loan sale agreement. 

Establish a Debt Service Payment Reserve

One way to mitigate against this risk is by establishing a debt service payment reserve at the closing of the loan being sold, with funds sufficient to satisfy the loan payments during the period in which an early payment default can occur. Provided the terms of the loan sale agreement permit the use of a reserve to satisfy early payments, the Seller can fully mitigate against a repurchase obligation triggered by an early payment default using this method.

Limit the Scope of What Constitutes an Early Payment Default

Alternatively, if a debt service reserve was not contemplated at loan closing, or if the Purchaser is not agreeable to permitting a debt service reserve to overcome early payment default provisions in the loan sale agreement, then Sellers should seek to limit the scope of what constitutes an early payment default. If the loan sale agreement contemplates a repurchase obligation for an early payment default by the loan borrower during any of the first three loan payments following closing of the loan sale, for example, Sellers can seek to negotiate the repurchase obligation to only be triggered if the borrower fails to make each of the first three loan payments during such period.

Reduce Repurchase Period

Another mitigation strategy is to reduce the repurchase period from the first three loan payments following closing of the loan sale, to each of the first two loan payments. 

Other Solutions

In the event you receive a demand from the Purchaser to repurchase a loan, there may still be other solutions available, such as curing the defaulted payment or paying some other fee representing the difference between the value of loan if it was performing, versus the value of the loan as a nonperforming loan. 

What is important to bear in mind is that repurchase obligations can be incredibly cumbersome for the loan Seller reliant on the capital received from the loan sale to continue operations, particularly when it comes to new originations. Furthermore, if a Seller is forced to repurchase a nonperforming loan, the Seller then needs to deal with the servicing impacts of a nonperforming loan, and attempt to exercise impaired remedies available to the Seller (as lender under the promissory note) given the COVID-19 outbreak. For further discussion regarding the evaluation of remedies in connection with COVID-19 defaults by borrowers, see Managing Loan Defaults During the COVID-19 Crisis.

Alternatively, the Seller can offer the nonperforming loan for sale to another Purchaser, but will likely need to offer the loan for sale at a discount.