Scratch-and-dent volume appears to be on the rise
March 28, 2023 8:00 AM
After two years of record mortgage volumes , the government-sponsored enterprises are finally checking the loans they purchased during this time frame to see if they comply with the guidelines.
As a result, more mortgages with underwriting dings are being put back to the originator. In turn, that is fueling growth in the scratch-and-dent marketplace.
However, many of those loans havecoupons of 3% or lower , which, besides the additional supply coming on to the market, is keeping prices down.
As a result, more mortgages with underwriting dings are being put back to the originator. In turn, that is fueling growth in the scratch-and-dent marketplace.
However, many of those loans have
Hot topic in Vegas
It was the No. 1 topic of discussion at the recent SFIG conference in Las Vegas, John Toohig, managing director and head of the whole loan trading group at Raymond James said.
"That was a lot of chatter around it, a lot of people saying hey, if you have any of that on file, I'd like to see it,'" Toohig said. "Lots of talk, folks want to know where they can find it."
Another SFIG attendee, Hal Hermelee, senior managing director at Rams Mortgage Capital, agreed about the level of discussion regarding this asset class during the conference.
"There seems to be supply with the agencies pushing these repurchases back to the originators and we expect that to continue [creating] a decent amount of supply," Hermelee said.
But it's brought in new investors as well. "For bigger pools you're getting aggressive buyers both from the street and other non-bank investors and certainly these big pools are trading very tight, certainly a lot tighter than some of the smaller pools," said Hermelee.
Those funds had raised money to purchase distressed assets and now need to put it to work.
"In just the year to date we've seen, call it about $1.5 billion of scratch-and-dent product on the market," Hermelee said. "And many of these originators don't have warehouse lines [such as hospital lines] to hold seasoned loans."
Mortgage Industry Advisory Corp. is now seeing more deals of these loans coming through than in the recent past, said Nicholas Dorn, senior vice president, whole loan sales.
"We see a pretty steady flow of scratch-and-dent generally," Dorn said. "We'll trade small and large packages and there has definitely been an increase or a pickup in larger packages."
"That was a lot of chatter around it, a lot of people saying hey, if you have any of that on file, I'd like to see it,'" Toohig said. "Lots of talk, folks want to know where they can find it."
Another SFIG attendee, Hal Hermelee, senior managing director at Rams Mortgage Capital, agreed about the level of discussion regarding this asset class during the conference.
"There seems to be supply with the agencies pushing these repurchases back to the originators and we expect that to continue [creating] a decent amount of supply," Hermelee said.
But it's brought in new investors as well. "For bigger pools you're getting aggressive buyers both from the street and other non-bank investors and certainly these big pools are trading very tight, certainly a lot tighter than some of the smaller pools," said Hermelee.
Those funds had raised money to purchase distressed assets and now need to put it to work.
"In just the year to date we've seen, call it about $1.5 billion of scratch-and-dent product on the market," Hermelee said. "And many of these originators don't have warehouse lines [such as hospital lines] to hold seasoned loans."
Mortgage Industry Advisory Corp. is now seeing more deals of these loans coming through than in the recent past, said Nicholas Dorn, senior vice president, whole loan sales.
"We see a pretty steady flow of scratch-and-dent generally," Dorn said. "We'll trade small and large packages and there has definitely been an increase or a pickup in larger packages."
Fed action impacts
At the start of the year generally expected the Federal Reserve might reverse course on rate hikes, so they decided to keep those assets until prices get better. Prior to the recent failures of Silicon Valley Bank and Signature Bank , signs were the Fed was likely to boost rates 50 basis points at its March meeting.
However, because of the instability created by those failures, the Federal Open Market Committeeonly boosted rates 25 basis points. That increase is not likely to improve the pricing of scratch-and-dent packages.
"I think now originators are coming to grips with the fact that that's not as likely a scenario and they may need to move those assets," Dorn said.
Furthermore, even the buyers need to finance their purchase of these loans, and those facilities typically involve an adjustable interest rate, so a Fed increase also raises their costs.
To Sharon Reichhardt, executive vice president of operations at Aces Quality Management, what happened with the book of business created during the pandemic is very reminiscent of what happened during the boom era of the mid-2000s.
"I think we kind of let loose a little bit of the reins," Reichhardt said. "Folks were just trying to get through their day, close their loans, and unfortunately, as typically happens, we see several months or even a couple years later where some of those bad apples are bearing fruit so to speak, and now we're seeing more and more loans getting kicked out."
However, because of the instability created by those failures, the Federal Open Market Committee
"I think now originators are coming to grips with the fact that that's not as likely a scenario and they may need to move those assets," Dorn said.
Furthermore, even the buyers need to finance their purchase of these loans, and those facilities typically involve an adjustable interest rate, so a Fed increase also raises their costs.
To Sharon Reichhardt, executive vice president of operations at Aces Quality Management, what happened with the book of business created during the pandemic is very reminiscent of what happened during the boom era of the mid-2000s.
"I think we kind of let loose a little bit of the reins," Reichhardt said. "Folks were just trying to get through their day, close their loans, and unfortunately, as typically happens, we see several months or even a couple years later where some of those bad apples are bearing fruit so to speak, and now we're seeing more and more loans getting kicked out."
Quality still slipping
The company recently released its third quarter 2022 quality control trends reports and the findings were not good as the defect rate reached a high since Aces started compiling this information at 2.47%. That was up from 2.05% in the second quarter.
'With purchase originations down nearly 20% quarter-over-quarter and close to 50% year-over-year, lenders are fighting to keep every potential piece of business that comes their way and, perhaps, becoming more aggressive in their borrower qualifications," said Nick Volpe, Aces executive vice president. "Riding the line on eligibility provides little margin for error."
Appraisal related manufacturing defects fell for the third straight quarter. Income and employment defects were also slightly lower, but still had the largest share at 24.66% of all findings.
But errors in assets, credits and liabilities all increased on a quarter-to-quarter basis.
'With purchase originations down nearly 20% quarter-over-quarter and close to 50% year-over-year, lenders are fighting to keep every potential piece of business that comes their way and, perhaps, becoming more aggressive in their borrower qualifications," said Nick Volpe, Aces executive vice president. "Riding the line on eligibility provides little margin for error."
Appraisal related manufacturing defects fell for the third straight quarter. Income and employment defects were also slightly lower, but still had the largest share at 24.66% of all findings.
But errors in assets, credits and liabilities all increased on a quarter-to-quarter basis.
WFH affects loan creation
The pandemic only complicated what normally goes on during the manufacturing process during periods of high volume, Toohig added.
"Let's be honest, our work conditions for the last couple of years haven't been perfect," Toohig said. "People have beenworking from home and we all remember back to 2021 and what that was like. We hadn't figured out Zoom and our workflows and processes."
As a result, production mistakes were made. Now Fannie Mae and Freddie Mac are doing their reviews and finding a few holes in those loans, Toohig said.
Aces noticed errors in documentation primarily, not the more concerning errors that took place in the past.
"For me, it points to the fact that because the volume is what it was, and people were losing control of what their processes were," Reichhardt said. "[Lenders] were allowing things to slip by because they didn't have the time to really properly review, stop, fix, whatever the case may be."
"Let's be honest, our work conditions for the last couple of years haven't been perfect," Toohig said. "People have been
As a result, production mistakes were made. Now Fannie Mae and Freddie Mac are doing their reviews and finding a few holes in those loans, Toohig said.
Aces noticed errors in documentation primarily, not the more concerning errors that took place in the past.
"For me, it points to the fact that because the volume is what it was, and people were losing control of what their processes were," Reichhardt said. "[Lenders] were allowing things to slip by because they didn't have the time to really properly review, stop, fix, whatever the case may be."
Fannie adds prefunding audits
In the same seller guide announcement where the headline was Fannie Mae's change to the appraisal process , the GSE also put in prefunding audit requirements, effective Sept. 1, but the agency is encouraging them to put them in place right now.
Each month, the lender must review 10% of the prior month's total number of closings, or 750 loans.
This change is a reflection of what Fannie Mae is seeing, Reichhardt believes.
"Folks are not spending enough time looking at loans prior to closing," she said. "They feel they have to put in some of those new requirements to kind of level set and get people back within their guardrails so to speak."
Right now, however, with nearly $10 trillion of loans originated during the recent crush, the size of the market is around $25 billion, said Jack Macdowell, chief investment officer at alternative asset manager The Palisades Group.
Last year, he estimated nearly $10 billion of scratch and dent came available, but "a lot of guys didn't really want to accept the pricing, and so, some of those offerings did not transact," Macdowell continued.
Each month, the lender must review 10% of the prior month's total number of closings, or 750 loans.
This change is a reflection of what Fannie Mae is seeing, Reichhardt believes.
"Folks are not spending enough time looking at loans prior to closing," she said. "They feel they have to put in some of those new requirements to kind of level set and get people back within their guardrails so to speak."
Right now, however, with nearly $10 trillion of loans originated during the recent crush, the size of the market is around $25 billion, said Jack Macdowell, chief investment officer at alternative asset manager The Palisades Group.
Last year, he estimated nearly $10 billion of scratch and dent came available, but "a lot of guys didn't really want to accept the pricing, and so, some of those offerings did not transact," Macdowell continued.
Selling at a discount
When an originator buys back a mortgage and fixes it up for resale, typically it's sold for a four to eight point discount.
"Today, it's a 20 to 30 point discount and so if you just kind of run the quick math on a $300,000 loan, historically they're taking less than a $20,000 hit," Macdowell said. "Today they're taking over a $70,000 hit per loan."
On the other side, while the discounts might be attractive to potential buyers, they are usually looking for a quick exit strategy. Few purchase these loans to portfolio them, even as those in the market today are of strong credit quality.
In the normal course of business, a lag exists between the time the loan is sold on the secondary market and when Fannie Mae and Freddie Mac look at what they bought. Observers noted that it got extended as the GSEs were crushed with volume.
"Given the reduction in origination volumes that we're seeing today, it's freeing up more of their resources to really review these loans," Macdowell said. "But even last year we started to see the volumes pick up quite a bit in scratch and dent and we would expect that to continue this year."
"Today, it's a 20 to 30 point discount and so if you just kind of run the quick math on a $300,000 loan, historically they're taking less than a $20,000 hit," Macdowell said. "Today they're taking over a $70,000 hit per loan."
On the other side, while the discounts might be attractive to potential buyers, they are usually looking for a quick exit strategy. Few purchase these loans to portfolio them, even as those in the market today are of strong credit quality.
In the normal course of business, a lag exists between the time the loan is sold on the secondary market and when Fannie Mae and Freddie Mac look at what they bought. Observers noted that it got extended as the GSEs were crushed with volume.
"Given the reduction in origination volumes that we're seeing today, it's freeing up more of their resources to really review these loans," Macdowell said. "But even last year we started to see the volumes pick up quite a bit in scratch and dent and we would expect that to continue this year."
Small number of buyers
The number of buyers is limited, he added, although they come in various sizes. Those larger purchasers are able to bid up the larger pools, because they likely have a lower cost of capital. "Oftentimes, we're seeing these larger pools transact at higher prices and tighter yields for that reason."
However, institutional buyers have the scale and efficiencies as the fixed costs are the same whether it is a small or large package, Toohig noted.
The sellers are likely thinly capitalized companies that lack the capacity to hold these loans on their warehouse lines, Toohig said.
"So you'll see a pool of 10 loans here and 30 loans there, 50 loans here from different folks that are dealing with those repurchases and they come out for bid in dribs and drabs," Toohig said.
For most buyers, the exit strategy is to clean up the issues and then resell the loans. That usually involves enticing the borrower into refinancing. But today's interest rate environment doesn't make that feasible.
However, institutional buyers have the scale and efficiencies as the fixed costs are the same whether it is a small or large package, Toohig noted.
The sellers are likely thinly capitalized companies that lack the capacity to hold these loans on their warehouse lines, Toohig said.
"So you'll see a pool of 10 loans here and 30 loans there, 50 loans here from different folks that are dealing with those repurchases and they come out for bid in dribs and drabs," Toohig said.
For most buyers, the exit strategy is to clean up the issues and then resell the loans. That usually involves enticing the borrower into refinancing. But today's interest rate environment doesn't make that feasible.
Unhappy with the prices
When these packages came to the market last year, many of the sellers were unhappy with the prices being offered, said Michael Lima, managing director, correspondent lending at Click n' Close , an Addison, Texas-based mortgage banker.
"It's even worse now," Lima said. "Because scratch and loans trade like a bond; when interest rates go up, the yield requirements from the buyers' goes up." As a result, the prices they can fetch declined.
"A lot of these sellers just refused to take their medicine last year and so they held these loans hoping that something would change or the market would change," Lima said. "And it's actually gotten worse."
Meanwhile, scratch-and-dent buyers are opportunistic. "They're not here with a mission to provide liquidity," said Lima. "They're on a mission to provide returns to their owners or to their investors."
Lima was recently at the Lenders One conference and the feeling among originator attendees was that if the GSEs were going to do quality control, it should be done quicker so if a buyback is required, they are not holding paper that is now out of the money for a refinance to resolve the error.
"Don't make me buy back 4% loans now, where the market is 7%, as well as loans that have already gone through foreclosure, where I didn't have a chance to remediate my loss," Lima said.
Click n' Close bought whole loans fromFirst Guaranty when the now-defunct mortgage lender ran into its liquidity issues.
"We went through all those loans," Lima said. "We found actually they had a very good manufacturing process." But these loans, like some other scratch and dent in the market, still have a problem for the buyer.
"The only thing for us: the risk is that we don't have a counterparty if something is wrong after the fact," he said.
The people that purchase these from the originator also don't want these assets for the long-term.
"Most buyers do not want to buy and hold 30 year mortgages," said Lima. "People want to buy and liquidate and make money in the short term, they don't want to have a duration of 10 years."
"It's even worse now," Lima said. "Because scratch and loans trade like a bond; when interest rates go up, the yield requirements from the buyers' goes up." As a result, the prices they can fetch declined.
"A lot of these sellers just refused to take their medicine last year and so they held these loans hoping that something would change or the market would change," Lima said. "And it's actually gotten worse."
Meanwhile, scratch-and-dent buyers are opportunistic. "They're not here with a mission to provide liquidity," said Lima. "They're on a mission to provide returns to their owners or to their investors."
Lima was recently at the Lenders One conference and the feeling among originator attendees was that if the GSEs were going to do quality control, it should be done quicker so if a buyback is required, they are not holding paper that is now out of the money for a refinance to resolve the error.
"Don't make me buy back 4% loans now, where the market is 7%, as well as loans that have already gone through foreclosure, where I didn't have a chance to remediate my loss," Lima said.
Click n' Close bought whole loans from
"We went through all those loans," Lima said. "We found actually they had a very good manufacturing process." But these loans, like some other scratch and dent in the market, still have a problem for the buyer.
"The only thing for us: the risk is that we don't have a counterparty if something is wrong after the fact," he said.
The people that purchase these from the originator also don't want these assets for the long-term.
"Most buyers do not want to buy and hold 30 year mortgages," said Lima. "People want to buy and liquidate and make money in the short term, they don't want to have a duration of 10 years."
Limited resecuritization opportunity
Securitization had been one possible outlet for these mortgages, but Gunes Kulaligal, managing director at investment bank and advisory firm Stout, found the last pure scratch-and-dent issuance was in 2017.
It doesn't mean that some of these loans might have been packaged innonperforming or reperforming pools.
Non-qualified mortgage securitizations are a proxy for this market, because of the credit component, Kulaligal explained.
While more non-QM deals came to market in the first quarter than in the recent past, all of them were from seasoned loan pools.
"You're seeing triple A's priced at 6%, 7% yields," Kulaligal said. "So this is not a favorable time for anyone to securitize a product."
Scratch-and-dent loans are not homogenous. Some are performing, some aren't. Credit scores could be as low as 650 or as high as 740, he said.
"But in general, again, it's not a good time to be selling any credit asset, let alone one that is known to be scratch-and-dent," Kulaligal said.
It doesn't mean that some of these loans might have been packaged in
Non-qualified mortgage securitizations are a proxy for this market, because of the credit component, Kulaligal explained.
While more non-QM deals came to market in the first quarter than in the recent past, all of them were from seasoned loan pools.
"You're seeing triple A's priced at 6%, 7% yields," Kulaligal said. "So this is not a favorable time for anyone to securitize a product."
Scratch-and-dent loans are not homogenous. Some are performing, some aren't. Credit scores could be as low as 650 or as high as 740, he said.
"But in general, again, it's not a good time to be selling any credit asset, let alone one that is known to be scratch-and-dent," Kulaligal said.
Bank failures sideline some buyers
The market is also likely to be affected by failures of three regional banks : Silicon Valley Bank, Signature Bank and Silvergate Bank.
Those events are likely to make some potential purchasers more conservative in their outlook and push them to the sidelines, Hermelee said.
"Some of the banks are participating in the scratch-and-dent market, they have sort of a smaller box," Hermelee said. "Their criteria is higher quality loans that have better loan characteristics and parameters."
Certain regional banks liked buying scratch-and-dent in the past because they are high credit quality loans along the yields that they can earn when they're buying them at a discount when keeping them in portfolio, Macdowell said.
"Volatility increased significantly due to the cracks that have recently emerged in the banking system," Macdowell continued. "Palisades' view is that the scratch-and-dent product that comes out in the near term will be priced based on the current level of uncertainty in the markets."
Originators who need liquidity will be forced to sell but those without such issues might be able to wait until pricing firms. At the same time "we may see smaller pools in near term with the bigger guys — and bigger scratch-and-dent offerings — sitting tight until volatility normalizes," Macdowell said.
Still, an increase in scratch-and-dent coming onto the market is likely to occur through the end of 2023.
"I think we'll see more of it," Toohig said. "It was certainly one of the more talked about items in Vegas."
Those events are likely to make some potential purchasers more conservative in their outlook and push them to the sidelines, Hermelee said.
"Some of the banks are participating in the scratch-and-dent market, they have sort of a smaller box," Hermelee said. "Their criteria is higher quality loans that have better loan characteristics and parameters."
Certain regional banks liked buying scratch-and-dent in the past because they are high credit quality loans along the yields that they can earn when they're buying them at a discount when keeping them in portfolio, Macdowell said.
"Volatility increased significantly due to the cracks that have recently emerged in the banking system," Macdowell continued. "Palisades' view is that the scratch-and-dent product that comes out in the near term will be priced based on the current level of uncertainty in the markets."
Originators who need liquidity will be forced to sell but those without such issues might be able to wait until pricing firms. At the same time "we may see smaller pools in near term with the bigger guys — and bigger scratch-and-dent offerings — sitting tight until volatility normalizes," Macdowell said.
Still, an increase in scratch-and-dent coming onto the market is likely to occur through the end of 2023.
"I think we'll see more of it," Toohig said. "It was certainly one of the more talked about items in Vegas."
