Originating a non-conforming loan that's sellable on the secondary marketJames L. Smithnon-conforming loans, bundling If you've even written one non-conforming loan, chances are that you've had your eye on the secondary market. What you might not know is that your institutions ability to sell that loan on the secondary market starts when you originate it. The secondary market for mortgages traces its history back to the mid-1930s. In 1938, the government created Fannie Mae to buy and hold Federal Housing Administration-insured loans. Fannie Mae was designed to purchase loans from lenders freeing up their funds for other mortgages. But those were and continue to be for conforming mortgages only. Today, the secondary mortgage market is a multi-billion dollar industry that ranges from bundling a variety of mortgages to selling one loan at a time, both conforming and non-conforming. These transactions are sold to large institutional investors and through Wall Street firms. Large and small institutions have the ability to bundle their loans and sell them on the secondary market, provided they are properly originated. So, how do you write non-conforming loans that will appeal to Wall Street's appetite for investments? Here are the questions you need to answer: What type of loan is it? Is it sub-prime, alt-A or a distressed asset (scratch and dent)? The type of asset you're originating leads to different directions in defining the risk of the asset. The amount of perceived risk will be a function of price. Also, you need to consider the avenues you have for selling the loan. For example, Freddie and Fannie do not typically buy non-conforming loans. Is it a first-lien or second-lien property? This is another matter where the perceived risk will affect the price. For example, because there is a higher loss severity associated with second lien property, you will need to compensate for the additional risk with an increase in interest rate. How seasoned are the assets? Are they newly originated? Five years old? That determines just how dependable the appraisal and other origination documents will be. If you have an appraisal that is 30 days old, obviously you can expect it to have a better chance to reflect the value of the property today than an older appraisal. If you have an older appraisal, and no one's seen the property in three years, a lot could have changed. If you have a lending decision based on information that old, the value could have changed a lot since the loan was written. What are the demographics where the loan was originated? What state is it in? There are specific foreclosure frequencies and loss severities associated within certain regions of the country. Think of Florida or Louisiana and what's happened there to property values. Is the property in a FEMA flood zone? Is it in the inner city? Is it a row home? Is it in one of the non-disclosure states? There are 13 non-disclosure states where information about properties can't be shared outside the state. They are Alaska, Idaho, Indiana, Kansas, Louisiana, Mississippi, Missouri, Montana, New Mexico, North Dakota, Texas, Utah and Wyoming. Selling loans in these states presents its own set of challenges. What are your goals for the exit strategy of the loan? Wall Street firms can create investment structures to tailor to your appetite for risk. Are you willing to hold onto any kind of risk on the asset? Do you want to sell the loan and walk away with no recourse, or will there be some kind of recourse involved? The answer to this decision will dictate the investment opportunities you have. Do you want to keep it on your balance sheet? If you're going to securitize the loan and hold it on your balance sheet, there are several types of bond structures that can be created for you. What is the financial position of the originating company? Is your institution large or small? If the financial position of the originating company is strong, it can influence the terms of the due diligence process. But don't think that because you are a small institution that this is not a game for you. There are specific investment opportunities for different sizes of companies. If you're a small savings and loan and want to sell to Wall Street, there are ways. Some Wall Street operations actually have appetites for smaller mortgage companies rather than larger ones. Don't assume that if you're a small institution, you don't have access to all aspects of the secondary market. In fact, there are many Wall Street firms that have operations specifically to deal with small institutions. What kind of volume are you originating each month? If you can bulk up many loans at a time, you'll get better pricing than if you try to sell off one or two loans at a time. What are the financial objectives of selling the asset? Do you want cash today or a cash flow over a period of time? Do you want to have an equity piece in the transaction? Do you want the asset to remain as part of your balance sheet? All of these factors affect the pricing you'll get. What is the strength of your representations and warrants? Representations and warrants represent your institution's ability to make restitution to the purchasing firm should there be certain problems with the loan. What is your institution's ability to purchase assets back or put in non-performance penalties? If you sell a loan and the first payment defaults or some sort of fraud is discovered, what can your institution do to remedy the situation? If your institution were willing to take back that loan, the pricing would be affected. If you were so small that you couldnt buy the loan back, the pricing would be lower to cover the risk. What are your lending practice goals in the future in the non-confirming market? How do they relate to your institution's long-term financial objectives? Where do you want your relationship with the secondary market to go? Are you interested in selling large transactions in bulk or do you just want to get rid of a few loans? Do you want to involve yourself with the non-conforming lender for the long term? If so, it makes sense to start developing relationships with Wall Street. There are more things you can do if want to be involved long term rather than short term. Wall Street firms will bend over backwards if you want a long-term relationship. Serious entry into the secondary market for non-conforming loans requires a commitment on the part of a financial institution. Most prefer to bring in outside help that is familiar with the landscape and understands that one size doesn't fit all. Outside vendors like ours take on the responsibility of tailoring an institution's due diligence processes so that they can create the most saleable asset in the secondary market possible. The key to choosing such a provider is to examine their lending experience with marketing loans on the secondary market. Look for length of time on the secondary market, depth of experience as both lenders and working professionals and an understanding of what Wall Street wants. In the end, you'll get a due diligence process on the assets originated that is specifically related to the exit strategy you want. Remember, one size doesn't fit all, but almost all lenders can develop their own expertise in originating saleable loans. The bottom line is that Wall Street's appetite for these kinds of loans continues to be insatiable. It's time your institution learned how to feed that beast and reap the rewards. James L. Smith is the executive vice president of Fiserv Lending Solutions-Portfolio Services, a risk management firm and subsidiary of Fiserv Inc. based in Boulder, Colo. He may be reached at (720) 565-9474.
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