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Navigating Distressed Asset Investment

home pricesTurbulent times create opportunities and uncertainty. How do you identify what is a potential good investment versus a risky bet? Operational expertise and track record should be required from investors who are presented with opportunities in uncertain times. Asset-backed investments can provide excellent returns and reduced risk if sourced, priced, and managed effectively. Mortgage and real estate have always provided good returns but can be especially profitable during uncertain times.

The Non-Performing Loan: 2020 outlook 

The cracks in the U.S. economy started to appear before COVID-19 in March, laying a foundation for increased opportunity in NPL. However, the COVID-19 onset has changed the landscape quite dramatically. The HUD HECM auction scheduled for mid-March—an auction of defaulted reverse mortgage loans where the properties are vacant and borrowers deceased—was postponed as COVID-19 came to a head. From mid-March till June, the non-QM mortgage market collapsed and fix-and-flip lenders started seeing increased defaults and late pays. As we head into Q3 2020, we are seeing a dramatic increase in defaults on previously modified mortgage loans as well as REO. From a portfolio manager’s perspective, a lack of transparency of how COVID-19 will play out over the next 24 months is very concerning. Portfolio managers base their models and expectations on assumptions generally agreed upon by their peers to forecast cash flow and performance. There is very little consensus on what the next 24 months will look like, causing forecast models to vary widely. As we head into Q4 2020, portfolio managers of large, mortgage-related, asset-backed investments will have to pick a track and execute a risk mitigation effort to gain certainty on 2021 performance. Because of this, we should see a good amount of NPL and REO come to market as risk managers look to reduce their exposure on a subset of high-risk assets and start fresh in the new year.

The biggest question that industry professionals must ask themselves is how the market will look further into the year. The first point to that discussion is that COVID and its consequences will stay for at least 24 months. The latest long-term mortgage default projections from many analysts is now hovering around the 7% range along with an unemployment rate of anywhere from 9–12%. Mortgage defaults will most likely hit FHA the hardest along with formerly modified mortgage loans. However, the long-term numbers will depend on 1) the expiration of the supplemental unemployment benefits that occurs at the end of July, 2) a further increase in the unemployment rates, continuing jobless claims, and 3) potential decline in home values.

Luckily for the economy, the unemployment rate estimations of 14% in April and 20% in May never came to fruition. In June, U.S. employers added 4.8 million new jobs and the unemployment rate dropped to 11.1%. Still, the Federal Reserve experts expect the unemployment rate to stay in the 9–12% range for at least 24 to 36 months. The second straight monthly increase in retail sales reported by the Commerce Department on July 16 is mostly attributed to the government's additional weekly $600 checks for the unemployed, a benefit that ended on July 31. The program expiration will leave millions of gig workers and the self-employed, who do not qualify for regular state unemployment insurance, without an income.

The growing amount of NPL and REO trend will be developing towards the third and fourth quarters of this year. I believe the HECM auctions will continue unimpacted by the COVID issue, and I anticipate increased delinquency on FHA portfolios due to the lower underwriting criteria as this product is designed to increase homeownership in underserved communities. Unfortunately, these types of borrowers may be more susceptible to job loss during the COVID crisis. FHA loans are now about 20% of the origination space, compared to about 2% of origination in pre-2008.

After the Big Crash—NPL Market Health Check   

The distressed assets environment in 2020 looks stronger compared to 2008. "We'll see a consistent flow of NPL and distressed debt over the next 18 to 24 months. That means a steady flow and lots of opportunities to deploy capital.

The 2008 distressed market was caused by the financial crisis, poorly underwritten loans, and slow government reaction. It resulted in a big and fast crash with very steep value declines. The 2020 financial markets are strong despite seeing an increase in distressed assets. The stock market continues to do well, bouncing back after COVID. The sharp rebound in June was followed by new records in July, with the S&P 500 coming back to the pre-pandemic levels and the Nasdaq 100 jumping to the most since April.

Home values remain strong and there is no indication of sharp value declines in the coming months. Some housing bubbles may appear due to the immediate shut down of the economy in March and the increase of home buyers scrambling take advantage of the low interest rates in May and June. It will be interesting to see the results of the rush to buy homes in May and June in combination with forbearances expiring in July. The result of increased home purchases with increased defaults may cause a short-term dislocation in the market. No matter what, we're not catching a falling knife, as we used to say when we bought NPL back in the 2008 crash. In the 2008 crash it was a race against the clock to liquidate or get assets re-performing because home values were dropping so quickly.

Low interest rates also provide stability in a distressed marketplace. Low interest rates keep the housing market active, thereby creating liquidity as we put homes back on the market for re-sell. Interest rates are at historic lows and they are not expected to increase anytime soon.

Steady home values, low interest rates, and an elevated unemployment rate have created a very stable distressed investment landscape. The distressed market is usually accompanied by an unstable environment susceptible to swings the marketplace similar to what we saw in 2008. Today is a great time to be in the distressed asset space. There are going to be plenty of opportunities, and we have a stable financial market.

However, finding the right operating partner who has the experience and track record to manage assets in this type of environment can make or break your investment strategy.

Checklist for Your Operating Partner 

Fresh-faced and eager "distressed asset managers," thinking of the distressed space and the opportunities when jumping from one industry to another, sometimes decide that this is a great time to deploy capital and get outsized returns. Those managers generally miss the opportunities with many of them not surviving the current cycle, let alone the next one.

To pick the right operating partner you want to look at track record and history. You don't want to partner with someone who is just building a platform for this particular environment. You want to look for a partner that is in this space indefinitely. Here's a checklist for the investor looking for the right operating partner:

  1. Track record. The asset manager should have been in existence for several cycles, not just created for the current environment.
  2. Infrastructure. Nationwide counterparty, attorney, servicer, legal, broker, and contractor networks.
  3. Technology. Technology that creates transparency and risk management is required in this asset class. The asset manager must have a way to manage a high volume of data and counterparty relationships.
  4. Strong Balance Sheet. There should be a decent amount of assets under management or on the balance sheet.
  5. Experience in Structuring Different Types of Deals. There should be a diverse history of successful deal structures depending on the investor’s interests—either joint ventures, LLCs, trust, or Reg B formats.

About Author: Louis Amaya

Louis Amaya - Pemco - 8.5.2020
Louis Amaya co-founded and is the CEO of PEMCO Capital Management. PEMCO Capital Management provides an institutional platform for investors to gain exposure in niche sectors within the distressed residential mortgage and real estate markets. Over the firm’s history, PEMCO Capital Management has supported the acquisition and management efforts for prominent commingled and single-investor family offices, hedge funds, institutional investors, and private equity funds. PEMCO is now launching a Reg D fund to allow retail investors to participate in the funds institutional platform. Amaya is also the founder and host of Capital Markets Today, a podcast focusing on real estate and mortgage capital markets.

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