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Weekly UpdatesBanks, residential mortgage-backed securities (RMBS) investors and mortgage loan servicers must gain a complete picture of their real estate-owned (REO) expenses if they are going to effectively clean up their positions and maximize proceeds in the face of collateral depreciation. $ Mortgage loan servicers are facing an unprecedented volume of real estate to manage and, eventually, liquidate. According to the Mortgage Bankers Association's (MBA's) National Delinquency Survey (NDS), in the first quarter of 2009 the seasonally adjusted delinquency rate was 9.12 percent--the highest in MBA's records going back to 1972. $ With uncertainty surrounding the impact of President Obama's stimulus package, shifts in fiscal policy along with ambiguity around Treasury's Home Affordable Modification Program (HAMP) and Homeowner Affordability and Stability Plan, foreclosures will continue to be a serious problem. According to real estate information provider ForeclosureS.com, Fair Oaks, California, more than 200,000 foreclosures were completed in the second quarter of 2009. $ Unfortunately for the mortgage industry, most players are not structured to be significant or long-term owners of residential real estate, let alone manage and process such massive volumes. Each day a house sits on its books, an organization becomes saddled with mounting operational costs that can go unnoticed. Absent government-funded backstops, the growing volume of these assets will continue to drive up operating costs while consuming capital and liquidity. Figure 1 summarizes the challenges facing banks and servicers grappling with the process of managing and selling REO properties, and the corresponding solutions.
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Banks have two choices: continue to manage REO properties as if the "rebound" is imminent or government capital support is indefinite, or develop new cost-containment approaches and disposition tools that will address the significant deterioration taking place in the residential real estate market. What follows is a multistep plan that provides a roadmap for banks, RMBS investors and servicers for taking the latter approach and effectively managing the REO process in a sea of uncertainty.
From foreclosure to disposition: improving the process
Time lost is money lost in the REO market. It is a simple equation: The longer a distressed property sits on a bank's books, the more money the bank must spend to manage the property and the process for disposing of it. Consequently, executives need to combine old-fashioned execution with innovative strategies for minimizing costs associated with managing REO properties and for selling properties in a depressed real estate market.
To date, the industry's most prevalent--and lowest-cost--approach has been to focus on better pipeline management: compressing the time it takes to market REO properties. Some innovations in valuations, list-price strategies and workflow management have been highly effective in decreasing the amount of time between foreclosure sale and REO liquidation. This reduces the costs for such items as handling eviction, title reporting and resolution, appraisal, repairs, maintenance, taxes, utilities and hiring a real estate agent.
Another innovative strategy involves the use of better metrics to enable REO managers to create environments that refocus staff on the importance of speed. Examples of this include:
* Net proceeds to sales price will give the manager insight into how well transactions are managed. This accounts for the transactional costs and enables an executive to monitor them as part of the liquidation process. For example, if net proceeds divided by sales price went from 83 percent to 80 percent, an executive could surmise that closing costs are getting out of line.
* End-to-end loss severity compares the net proceeds gained in liquidating a property with the total amount of principal, interest and reimbursable expenses incurred. It can be effective in tracking hidden expenses (such as delinquency costs) and fees (such as legal expenses, resolution of title defects, and county and municipal assessments) from the moment the loan enters loss mitigation through REO liquidation. For example, for a property with a $100,000 loan with $10,000 in delinquent principal and interest, $5,000 in interest due over the course of the loan and $5,000 in fees, if a servicer nets $80,000 from the sale of the property, loss severity measures the differential between expenses and proceeds.
* Net present value (NPV) accounts for the time value of money. This enables servicers to compare a modification or short sale today with an REO liquidation in the future. A below-par offer on an REO today is compared against a potentially better offer in a few months. All the comparisons are leveled by discounting the cash flow and also applying capital costs.
* Finally, servicers should also consider another metric: the correlation between liquidation rates and loss severity. Using such analysis, a servicer might find it is not liquidating quickly enough as markets continue to decline, or that it is potentially a bit too aggressive with list-price reductions.
A dramatic increase in the volume of REO properties on the books has also forced players to innovate around staffing. Servicers have increased staff, often doubling or tripling size in the past two years. This trend has improved both the volume and rate at which properties move through the pipeline for some organizations.
Players have also relied heavily on outsourcing solutions to handle as much as 50 percent of their REO flows. But additional capacity alone does not equate to effectiveness.
Deployment of productivity tools for REO asset managers and for integrating with outsourcers has greatly improved productivity. Off-the-shelf workflow tools, outsource-provided solutions and even generic business-process-management applications have enabled servicers and outsourcers to improve case loads per full-time employee by two to three times--from the industry ideal of 150 files per asset manager to 300 or even more than 400.
Another innovation focuses on institutions leveraging their size while obtaining better valuation insight by going local. Historically, many firms managed lists of agents or outsourced the listing process to national firms. But by connecting directly with local real estate agents and brokerages, REO groups have been able to reduce the time and expense of property maintenance through service levels and commission reductions.
Given slowed sales velocity, organizations can quickly find and employ eager local real estate sales and home-staging professionals to make certain that properties are ready to be shown for sale. These local contacts are also vital to understanding the idiosyncrasies of specific property markets. A servicer's close relationship with a real estate broker can help a firm cut through the bureaucracy of obtaining accurate pricing information, as well as the complicated issues that can slow closing negotiations.
One of the few benefits of the foreclosure boom is that players are taking another look at rental strategies. Some servicers had a difficult experience with rentals following the Hurricane Katrina crisis. However, forecasts for an extended recession combined with an increasing supply of renters are changing their negative view.
Many former homeowners have now become renters, while few renters can find financing to become homeowners, This demand has created an increase in the number of investors willing to buy and convert REO properties into rental units. Because these investors often arrive with plans to modify the properties, institutions can work with them to speed the liquidation process and expend fewer resources to prepare a property for sale.
Banks and servicers can also improve community and local government relations by fostering the growth of affordable housing--a critical need in some areas. For example, according to a 2008 survey by the Washington, D.C.-based National Association of Home Builders (NAMB) and San Francisco-based Wells Fargo & Co., the Los Angeles and Miami metropolitan areas were two of the regions in greatest need of affordable housing.
Since that survey was done, foreclosures have risen in those markets: Miami is the worst-hit, according to Irvine, California-based RealtyTrac Inc., with more than 23,000 foreclosed properties. Los Angeles is second, with more than 13,000. Elected officials in and around these two cities--and many others like them--are looking for ways to foster and promote affordable housing; banks and other loan holders with the right strategies in place are in a position to assist them in their efforts.
For example, in January, Fannie Mae announced its National Real Estate Owned Rental Policy, a program that would enable renters in Fannie-owned foreclosed properties to stay in their homes. Through the program, eligible renters would be offered a new month-to-month lease with Fannie Mae, or financial assistance for their move to new housing if they choose to vacate the property.
When process improvement is not enough
Unfortunately, many organizations are finding that improving pipeline management is not enough as charge-offs and credit losses continue to mount. As the volume of foreclosures accelerates, they cannot move property fast enough, no matter what pipeline changes they embrace. According to RealtyTrac, the number of U.S. foreclosure filings rose to 3.2 million in 2008--an increase of 81 percent over 2007 and 225 percent over 2006.
Many REO organizations are now, or will soon be, working at or above capacity. Servicers not already experiencing difficulty will quickly find themselves unable to liquidate properties in a timely fashion, making it imperative that they learn to identify and manage the true, long-term costs of REO.
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