Restructuring and Renting: Can it Fix the Shadow Inventory Problem?

by devteam September 15th, 2011 | Share

Last month the Federal Housing Finance Agency (FHFA) askedrnfor input on a plan it is considering to augment the Real Estate-Owned (REO) dispositionrnprograms run by Fannie Mae and Freddie Mac (the Enterprises) and the FederalrnHousing Administration (FHA).  Therndeadline for proposals is tomorrow.  Radar Logic, a data and analytic firm, responded with an innovative dual proposal for developing “cashrnmarket equivalent” values for real estate assets and reducing the inventory ofrnowned real estate (REO).</p

The first of what Radar Logic refers to as its two prongrnapproach would allow for aggressively restructuring the delinquent mortgages heldrnby FHA and the Enterprises by replacing existing mortgage debt with a modifiedrnmortgage and a bundle of securities that would contain debt and equity elementsrn- a Equity Participation Certificate (EPC) – to either be retained by the entitiesrnor sold on a type of secondary market.  </p

Radar Logic maintains its proposal, if implemented, wouldrnsignificantly reduce the immediate loss on the loan that would occur throughrnforeclosure and offer the incentive of additional profit downstream for thernlender, for an investor, and for the homeowner should he remain current on the restructuredrndebt.  Using an example provided in thernproposal, the debt/equity scenario would work as follows.</p

Foreclosure Scenario</p

Loan in the original amount of $190,000 has been paid downrnto a current principal balance of $186,310. rnA foreclosure and subsequent sale of REO is estimated to recoverrn$99,000.  The loss suffered by thernEnterprise will be $88,000.</p

Restructuring Scenario</p

Based on borrower information and the appraised value ofrnhomes in the area the mortgage is restructured at $125,000.  This would result in a loss of $61,000, a 27rnpercent larger recovery than if foreclosed.</p

Radar Logic’s “EPC” Proposal</p

The proposal submitted to FHFA envisions the loan restructurernas outlined above plus the creation of an EPC which would package the $61,000 remainingrndebt along with the potential for any future increase in the equity value ofrnthe home.  The accounting result is tornconvert the distressed loans into a right to share in the upside appreciationrnof the relevant property.  The homeownerrnwill be granted a portion of the appreciation rights, giving him an incentivernto remain current on the new loan and maintain the condition of the property.  The lender could hold the EPC in anticipationrnof an increase in value of the underlying collateral or could sell it torninvestors.  The loss to the lender is, atrnthis point, still 27 percent less than through a straight foreclosure howeverrnthe scenario envisions selling the EPC for 10 percent of its face value, or $6,100rnfor a final realized loss that is 33 percent less than if the lender hadrnforeclosed and liquidated the REO.  </p

It is Radar Logic’s contention that “the initiation of thisrnprogram will reduce the perception of over-supply in housing significantly,rnwhich will cause the cash value of the participation certificates to increasernimmediately.  If the EPC portfolios heldrnby the Enterprises and the FHA are managed properly over time, all losses mightrnbe avoided and even a profit might be realized.</p

No new resources would be required to implement the programrnaccording to the proposal.  The strategy canrnemploy the resources that are currently focused on loan modifications such asrnHAMP and existing resources within the Treasury or Federal Reserve can executernthe required capital market activity.</p

The risks of such a program include redefault of thernrestructured loan.  The EPC model howeverrnmitigates this risk because rather than a straightforward elimination of debtrnit substitutes a security for the portion of the distressed loan that no longerrnrepresents normal value in today’s housing market.  This results in a reduction in payment forrnthe homeowner without an immediate and unrecoverable loss to the lender.  Further, as long as the similar guidelinesrnare applied, the default risk will be no higher than for other modificationrnprograms or for new borrowers under FHA supported programs. </p

The second risk is that no meaningful home pricernappreciation occurs.  Radar Logic feelsrnthat the rebalancing of supply and demand should result in an increase in buyerrnactivity and thus an increase in values.</p

The second prong of the company’s proposal is to rent vacantrnREO properties.  The plan currently underrnconsideration by FHFA is the bulk sale of REO to private, presumably institutionalrninvestors who would refurbish and rent them as business ventures.  Radar Logic finds two problems with thisrnproposal.  First, investors will only buyrnif they can forecast an adequate return on their investment which would requirerna discount that would result in a larger and permanent loss to the Enterprisesrnand ultimately the taxpayer.  Second, thernsale of these properties in bulk at fire sale prices will put further downwardrnpressure on the market.  This wouldrnresult in lower future appraisals based on these comps and still further pricerndepreciation as well as possible cancellation of pending sales because theyrncannot be financed.  The actual REO inrnquestion is only a small piece of the country’s inventory overhang so sellingrnit at distressed prices may undermine normal activity without the benefit ofrnsubstantially clearing the market and enabling renewed activity.</p

Radar Logic suggests having a bulk sale without the actualrnsale.  Properties would be organized geographicallyrnand bids sought from qualified private investors to restore and manage thosernhomes as investment assets on behalf of the government owners.  This would create private sector jobs in bothrnrehabilitation and management as well. rnBy retaining ownership the Enterprises and FHA will suffer fewer lossesrnthan a bulk sale would impose, immediately reduce the existing oversupply ofrnhomes for sale, and conceivably see a profit as the markets improve.</p

MND is interested in your feedback:  </p

-Do you thinkrnthe plan has merit?  </p

-Do you seerndisadvantages to this plan? rn</p

-What would you do to improve the plan or do you have a better one?   </p

Some suggestions to start the conversation:  </p

– Could the general public get involved with this plan? rnThis could be done by providing incentives to firms that would offerrnshares of the security, much like a mutual fund or a Real Estate InvestmentrnTrust, to small investors rather than limiting the opportunity to bigrninstitutional investors.  </p

-Could this evolve into an EPC to the REO rental plan?  The Enterprises and FHA could retain some ofrnthe properties but could mitigate their risk, reduce the criticism likely torncome from Congress if they appear to be competing with the private market, and givernthe private sector an investment opportunity by packaging the unrecovered lossrnand potential appreciation of the properties into securities just as isrnsuggested for the excess debt resulting from restructured loans.  Again we would advocate for providing anrnincentive that would allow participation by the small investor. </p

Please share your ideas or commentsrnbelow.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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