REO: A Staggering Problem, an Enormous Opportunity

Robert L. Labbé - May 19, 2008

No large scale foreclosure solution imminent:
The National Association of Realtors reported at the end of April that 18% or some 720,000 of the four million existing homes currently on the market had negative equity and were either short sales or foreclosures. With the apparent stalling of the FHA refinancing bill drafted by Rep. Barney Frank (D), no large scale foreclosure prevention bill is set to be enacted before the summer. The FHA bill would have provided $300 billion in loan commitments to refinance homeowners with negative equity. The bill would have allowed lenders and investors to refinance borrowers into an FHA insured loan provided they agreed to write down the principal amount of their loan to 85% of current value. For now it appears the House, Senate and administration are unable to come to terms on substantial foreclosure prevention reform, although expect a compromise in the near future.

Some help:
In the interim, HUD finally released a letter detailing the expanded FHA Secure program, which should facilitate a significant number of FHA refinance loans to borrowers who have missed a few payments within the past twelve months. This expanded program is helpful, but clearly not of sufficient scale in light of the magnitude of the problem.

A staggering number of foreclosure filings:
Notwithstanding these government lead efforts and others aimed at helping resolve a problem largely created by private enterprise, the US foreclosure crisis continues. The scale of the problem was recently described by Sen. Chris Dodd: "a staggering 8,000 families are filing for foreclosure every day". Industry experts estimate 1.5 million foreclosure filings in 2008, with roughly 50% of those filings, some 750,000, resulting in actual foreclosure. Brad Geisen, CEO of www.foreclosure.com, recently pointed out in a webinar entitled "The Truth Behind National Foreclosure Statistics", that much confusion surrounds the reporting of foreclosure statistics, with few sources distinguishing between pre-foreclosure figures (the Dodd number of 8,000) and actual foreclosure resulting in a bank owned home, known as real estate owned or REO. Geisen contends that the default percentage, roughly 1% of all loans in 2007, is around 2% today. All agree however that regardless of statistical differences the problem is real and massive in scale.

How can private enterprise help?
Part of the solution affords a significant profit opportunity for private investors who purchase REO properties from ailing financial institutions. Buying REO in bulk at discounts to present value can be of great benefit to all parties: the banks benefit by disposing of an unwelcome balance sheet asset and regaining liquidity, the buyer benefits from the discount to present value and the community benefits by having a new owner in the place of a stigmatized “bank owned” home who can presumably afford to maintain the property, pay property taxes, and start the home ownership cycle over again.

Surprisingly, pools of bulk REO are very difficult to find despite the times. Although an individual investor can certainly bid on REO properties a few at a time and obtain discounts in the range of 10% or so off of current value from local real estate brokers, finding bulk REO pools has become next to impossible in a world where billion dollar hedge funds and Ivy League asset and fund managers dominate the capital markets. The financial institutions have however made some room for a few mid sized buyers who either entered the market early, have a disposition strategy, may have a desirable ownership component, or who have proven an ability to close a purchase of an REO pool of anywhere from 50 to 500 properties in the past. These buyers typically purchase from $20 to $100 million in REO properties at significant discounts to present value and can obtain all important access to stress ridden asset disposition managers – the guardians of the holy grail of bulk REO pools who receive hundreds of phone calls a day from potential buyers, few of which are ever returned. An asset manager charged with disposing of perhaps a billion dollars worth of REO for a major institution will simply not risk working with a new, unknown counterparty, invest thirty days in a potential transaction with an untested buyer who may or may not close on all or even some of the assets in a bulk REO portfolio. Even institutions with the financial strength to make a bulk REO purchase will often have expertise in commercial real estate but little experience in dealing with residential assets or understand how to purchase REO assets in bulk, something which becomes evident very quickly to an asset disposition manager.

Those participants already in the REO market, motivated by large profit opportunities and a belief in an eventual real estate recovery, are purposefully or not doing their own part in restoring liquidity to the banks, helping local communities and tax starved municipalities and by their opportunistic foray into the market, actually helping create the recovery they are betting on.

Robert L. Labbé is President of MorCap Fund Advisors, LLC. He can be reached at rlabbe@morcapadvisors.com

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