It is no surprise that mortgage rates have dramatically increased over the past year. In July 2022, 30-year fixed rates for both conforming and high-balance loans had reached 5.375% according to sources such as Guaranteed Rate, which is up from the low 2% range in early 2021. Obviously, such an increase in rates can influence house prices as buyers try to buy a house they can afford.
However, the rise in interest rates goes far beyond just what buyers can afford for a new purchase. First, adjustable-rate mortgages will climb dramatically, which impacts homeowners trying to keep up with their mortgages by not going into default. Second, the Fed increased rates to stave off even more inflation than the country had been experiencing since the change in presidency. We might see a rise in non-performing loans (NPLs) as homeowners fight to keep up with inflation, as well as rising interest rates that impact mortgages and other borrowings such as credit cards and auto loans.
During The Great Recession, the US saw a huge wave of mortgage defaults. This was primarily due to a credit bubble, as lenders were too eager to make loans. There was little oversight regarding these loans and borrowers who should not have received loans still qualified. Fast forward 15 years and real estate prices have increased substantially to overcome the devastation of the previous drop. Thanks to Dodd-Frank, banks are now only allowed to make loans to borrowers who can demonstrate an ability to repay. All of this makes for a strong real estate market, and we should not experience the same wave of foreclosures. However, that does not mean we will not see them. When there is a spike in interest rates and inflation as we have recently experienced, homeowners can get behind in their mortgages. Without the government moratoriums put in place during Covid, banks will have to start foreclosing or sell off mortgages to keep within Federal guidelines of Reserve Requirements. Banks may try and work modifications or other remedies to assist homeowners, but sometimes there is not much the bank can do except file notices of default and start the foreclosure proceedings.
One major difference in today’s real estate world as compared to The Great Recession is that many homeowners have ample equity. The homeowner has the possibility to preserve some equity by selling their house rather than deal with foreclosure. However, many homeowners in the lower end of the market will still lose their homes. One reason is that the homeowner has not researched the value of their house; they just assume that if they cannot pay, they lose their property. Another reason is that some homeowners are headstrong about staying in their residence and trying to fight a legal battle, only to be on the wrong end. Unfortunately, by that time, it is too late to try and save their equity. Even when the lender points these things out, many borrowers stick their head in the sand and let the chips fall where they may.
Investors have been clamoring for yield so much that even NPLs were commanding unheard-of prices. When the economy was doing well pre-Covid, real estate prices were steadily increasing and there was confidence in the marketplace. However, in “normal” times, one might offer 50% +/- of the face of the NPL note, as there is a fair amount of work that goes into managing an NPL regarding foreclosure, forbearance, modifications, bankruptcies, and possible lawsuits by the borrowers. As interest rates rise and the supply of NPLs is sure to increase, one should expect the prices of the NPLs to decrease allowing investors to potentially pick up handsome profits.
In the early 1990s, the S&L crisis provided such opportunities to investors swooping up “bad loans” as the S&Ls were directed to unload these mortgages into the market very quickly. As the dust settled, these investors profited as they picked up loans or property at discounts only imaginable. Discounts of more than 60% were not uncommon. At such a discounted price, the investor appeared to risk very little. There was so much room for error, almost any loan to be purchased was worth the risk. We may not be in that same situation now due to restrictive banking regulations and the fact that real estate has held its own since The Great Recession. Despite this, there should be opportunities for investors to pick up discounted loans with fairly large margins; however, the average investor is prohibited from buying these loans due to the relatively large amount of capital needed to enter this space.
For those investors who have the wherewithal to participate in purchasing NPLs, they should have a sophisticated team to assist them. There will be a need for analysts to do a deep dive into the values of the property to which the loans are secured, contractors to help facilitate potential rehabbing of the property if/when the property reverts to the investor, legal analysts dealing with the various foreclosure laws in the states where the properties are located, and good real estate salespeople to not only give BPOs but help facilitate the eventual sale of the property or assist with the possible rental.
One strategy to consider is to approach the NPL borrower and try to re-write or modify the loan. Turning an NPL into a performing loan brings immediate cash flow. Because of the discount obtained in the purchase, the new note holder has the flexibility of making the note more attractive for the borrower. For instance, if a note that has a face value of $100,000 has 20 years to go, and has a note rate of 6% that was purchased for 60 cents on the dollar from the bank, the new note holder could offer to lower the balance to $90,000, reduce the interest rate to 5%, and have a great asset that can either be held for cash flow or sold in the secondary market.
One additional factor that may help in modifying the NPL’s notes is that according to Bank of America’s internal data, rents continue to rise. July 2022, year over year, showed an increase in rents of 7.4%. Most people want to keep their home, and if the lender can give them advantages to saving it, most homeowners will jump at the chance, especially when their alternative is to be thrown into a rising rent market. The lender must contemplate whether the strategy of keeping a homeowner in their home makes economic sense. Sometimes, evicting a homeowner and immediately selling the house may make sense. In some cases, the lender may invest money in rehabbing the property in-house for additional gain. However, the time it takes to rehab, the expense, the value of the house after rehab, and time to sell can be uncertain. When a homeowner is going to get foreclosed on, there are avenues to delay the inevitable, including filing bankruptcy. Due to Covid and court budgets, this delay may be prolonged more than the lender anticipates, especially in judicial-only states. Yet, the strategy of keeping the homeowner in place and working out a new deal can produce immediate cash flow, as the borrower will start making payments instantly. In addition, the costs to modify a note is less than a normal foreclosure cost.
The good news from the lender’s point of view is that, due to the purchase of these loans at steep discounts, the rate of returns of more than 15% is not uncommon. After the note is modified, the lender can flip the note to a note buyer as a performing note which will command a higher price than an NPL, or the lender may choose to keep the note for the cash flow. In the case of choosing to sell the note, the lender may be wise in waiting to experience six months of performance by the borrower, as most note holders desire. Otherwise, they may discount the note for uncertainty reasons, such as lack of history, more than the lender wishes.