FHA SINGLE FAMILY MORTGAGE LOAN SALE #2
Friday, April 19, 1996, Room 9282
Although FHA Single Family Mortgage Loan Sale #2 was very successful, a number of issues were raised during and following the sale, in post-sale discussions with bidders, that should be addressed. Listed below are a number of comments, issues and lessons learned that should be considered as FHA begins preparing for FHA Single Family Mortgage Loan Sale #3.
Improve, do not change Due Diligence Materials. Bidders were unanimous in the opinion that the due diligence materials were, "abundant, satisfactory and very helpful." The CD-ROMs were a huge success, as was the decision to provide BPO's on 100% of the loans. The abundant information and low cost lowered barriers to entry for small bidders allowing them to bid.
There were, however, some areas that could be improved:
- Payment histories should include payment due dates and amounts. The provision of 36 months of payment history very likely resulted in higher bids, for most bidders were surprised at the amount of cash flow these loans produced on average. During the investor feedback calls almost all bidders indicated that next time they would like to see the due date and the amount of each payment provided on the payment history.
- Provide all collateral files on CD-ROM. Bidders generally only came to the war room to review the collateral documents. The only servicing file document they were interested in was the forbearance agreements. To the extent that the collateral files and the forbearance agreements could be imaged and sent to bidders on CD-ROM, there would be even less need to come to the war room, which of course would further reduce due diligence costs for small bidders.
- Improve integration with field offices. Although the field offices are directed to stop all servicing activity with a borrower once the files are picked-up at the start of the due diligence period, some field offices continue to "service" the loans. Any servicing activity should be fully integrated with headquarters so that the sale team knows exactly what is happening and can make this information available to investors.
- Most bidders do not think it is necessary to provide BPO's on loans with balances under $10,000. SF#2 included about 1,300 loans with UPB of less than 10,000. It may be cost effective to consider not getting BPO's on loans under a certain dollar amount, or alternatively, all performing loans under a specified dollar amount. Several bidders indicated that they do not purchase BPO's for loans of this size.
Assumptions. To the extent possible, all assumptions should be based on time series data, i.e., foreclosure, loss, prepayment, percent interest collected and percent principal collected change depending on the number of years the loan has been serviced by FHA. The principal lesson learned from SF#1 and SF#2, is that the more robust the underlying data, the more likely the assumptions will be accurate and will be accepted by OMB.
FHA Input to Process. To the extent that all applicable FHA offices and personnel have input into the development of the value to government analysis, the better the result. Housing, Budget, the Comptrollers Office, PD&R all have a role to play, and should all be involved throughout the process.
Third Party Review. OMB would like a third party to verify the credit reform methodology, backup and calculations at some point during the process. The key issue is when. It is strongly recommended that any third party review be conducted after the sale date, as the value to government number is developed over time prior to sale and it may prove a logistical nightmare to have another party review prior to going to OMB. In addition, there is a major confidentiality issue at stake here. To the extent that the credit reform value for a particular sale is released prior to sale, it may impact pricing, which in the case of single family loans would likely result in a negative impact.
Qualification Statement. In order to receive a bid package FHA requires that bidders certify that they are qualified investors for purposes of exempting themselves from the SEC disclosure requirements. However, the current qualification statement states that buyer acknowledges that the sale "does not involve, nor is it intended in any way to constitute, the sale of a "security" within the meaning of the Act or any applicable federal or state securities laws." This language and/or the need for a qualification statement should be reviewed once again. Single family mortgages either are or they are not securities.
The Remarketing Issue. If it is determined that single family mortgages are securities and a qualification statement is necessary, FHA should direct its private counsel to opine as to whether or not winning bidders can remarket loans directly following closing as long as the loans are sold to qualified entities. The issues is that there is language in the qualification statement that on the surface seems to indicate that buyers are certifying that they are buying with the intention to hold the loans. The actual language is: "..buyer is bidding for, and will purchase the loans for its own account and not for resale with a view toward distribution within the meaning of the Securities Act of 1933."
In SF#2 the winning bidder did flip a small portion of the loans with the consent of counsel. FHA took the position that as long as the winning bidder's counsel held this opinion it was not within FHA's role to question this decision, i.e., the purchaser signed the qualification statement and their counsel advised them that selling to qualified investors was not a "distribution within the meaning of the Securities Act of 1933." For the purposes of future sale, and simply to be cautious, FHA should verify this position.
Provide more information on FHA servicing procedures. Several bidders indicated it would be helpful to understand better understand how payments are applied and how the loans are serviced while they are in FHA's possession. It is recommended that a section be added to the bid package that provides background on who does what, i.e., field offices, data contractors, headquarters, etc.
Provide more information on interim servicing capabilities. One bidder suggested that although the legal responsibilities for interim servicing are spelled out in the loan sale agreement, it may be helpful to identify if there are other servicing activities that either EDS or headquarters would consider providing, such as:
Best and Final rounds and Reofferings. These procedures were not specifically provided for in SF#1. In that sale, FHA retained the right to accept or reject all bids, and in the event of a tie bid provided for a best and final round among the tied bidders. The right to reoffer was assumed. In SF#2, the bid package and loan sale agreement specifically provided for a reoffering and a best and final round. The best and final language stated that FHA reserved the right to conduct a best and final round among the top bidders (either the highest bidders or any bidder within 5% of the highest bids for mortgage loan blocks or pool bids). This extra flexibility was a definite improvement over SF#1. The only recommendation for next time would be to further explain for how "bids or bidders" within 5% of the highest bid is determined. The issue is that in an optimization context it is a little hard to understand how the top bids are determined, and it is clearly better to provide a complete explanation in the bid package so as to eliminate any post sale misunderstandings.
Deposit Procedure. Currently, bid deposits can be sent one day prior to the bid day and on the bid day. The reason that deposits are accepted prior to the bid day is that FHA requires the wire tracking number to be on the bid form, and this number is only provided when the wire is sent. Hence, for all bidders that federal express their bids the wire must be send the day before. A couple of small bidders did not realize this and had to either send someone to Washington or send the package to someone in Washington. This issue should be clearly spelled out in the bid package and in the final supplement. One additional idea would be to send an envelope that had a checklist on the front that clearly outlined this issue, and require all bidders to send in their bids in this envelope.
( Optimization and Small Bidders. One of the issues that was raised with every bidder during the investor phone calls was whether or not they would bid next time. While the overwhelming majority of bidders stated they would bid again, a few indicated that they felt that optimization as currently constructed benefited the large bidders and that unless something was changed they may not be back. While it should be remembered that optimization maximizes proceeds, and normally those that try to tilt bid procedures in their favor or reduce competition generally are not the most aggressive bidders, anything that may retard the effort to create a retail market should be addressed.
Two small bidders stated that they believed that large bidders are able to use the spread make on performing loans to increase the price they pay on non-performing loans (which is what the small bidders were generally interested in). FHA's only concern should be that as many bidders as possible bid so that all bidders will price aggressively, which is what optimization is designed to do. However, if there is a perception that large bidders are unduly benefited by optimization as opposed to their natural advantages, i.e., lower cost of funds, and economies of scale, to the extent that some bidders drop out and competition slackens, the prices submitted by the remaining bidders could drop. Hence, there is a desire on the part of some bidders to further level the playing field, and to the extent that this can be done without eliminating the participation of large bidders FHA should make changes to the current optimization construction.
Several options were suggested, all of which need to be addressed in detail with the financial advisor for SF#3:
1. Create a small investor program. This will likely depress bid prices. Although you cannot keep the large bidders from participating (as lenders or money sources), you will eliminate some, and any decrease in competition by definition should depress prices.
2. Bid on each block separately either open outcry or sealed bid. This also will likely depress prices since most, if not all, of the large bidders will not participate. In addition, several small and mid-sized bidders indicated that it would be very costly to underwrite every single mortgage loan block.
3. Bid on each block separately but allow large bidders to place a floor on the number of blocks they will accept. This is potentially a solution, but Bell Labs has previously indicated that depending on the number of bids and bidders and floor amounts, their is a much higher probability that loans could remain unsold, i.e., too much overlap combined with different floors.
4. Only allow bids to include blocks within a single performance category. The idea is to use the existing five categories of loans (A - E), or create three large categories based on appropriate definitions to result is similar sized categories (about 200 blocks each with about $200 million in UPB), i.e., (a) basically performing, (b) totally nonperforming, and (c) stuff in between. Pool bids could only contain blocks from one category. Several small bidders stated they would much prefer this approach, and since the large bidders could still be assured of winning large blocks they should not oppose this structure.
The marketing plan must specifically target "retail" buyers. In theory, to the extent that the retail market does not participate, the large bidders ("wholesalers") can simply repackage and sell the loans at higher prices to the retail market in a different form following sale. In this fashion proceeds are sub-maximized. To the extent that the "retail" market can be brought to auction, the "wholesalers" will be forced to bid retail prices.
Some of the keys to developing the "retail" market are targeted advertisements, announcements, a vigorous follow-up calling campaign and strategic communications. As long as the bidding procedures and optimization construction are considered by the large bidders to be fair and not unduly tilted in the direction of small bidders, the large bidders will come to the table. However, traditionally, small bidders have not bid on nonperforming single family loans. Hence, the marketing plan should be designed to bring the small bidders to auction. This is best achieved by creating targeted marketing materials that highlight the low cost of due diligence, CRA eligibility, the even bidding playing field provided by optimization, etc. In addition, a well-designed strategic communications campaign can generate significant interest.
Make sure that bidders understand that these are sub-performing not non-performing loans. Several large and small bidders either did not bid or bid less than they should have on SF#1 because they thought the loans for sale were similar to the non-performing single family loans offered by the RTC. The differences need to be stressed during the calling campaign and in the marketing materials.
Loan Sale Agreement
Provide a Form of Bill of Sale and Acknowledgment Agreement. Several bidders indicated that their lenders required both a bill of sale and a form of acknowledgment from FHA. The bill of sale is necessary because bidders normally take possession of the collateral documents at closing, but in an optimization context, where it is unknown what loans will go to which bidders prior to bid, it is logistically impossible to arrange in time for closing. The acknowledgment agreement states that the winning bidder was in fact the successful bidder and that FHA will deliver the collateral documents to the lender on behalf of the winning bidder when available. In past sales, bidders were requested to send in their preferred forms, but it is clear that bidders would rather have a form that they can use or react to. The one note to consider with respect to the acknowledgment agreement is that FHA be held harmless for any malfeasance or improper behavior on the part of either the lender of the winning bidder.
Consider eliminating post sale servicing requirement that loans be serviced by a HUD-approved servicer. Considering that assignment program has been terminated, and assuming that borrowers can no longer receive 36 months of forbearance relief there is no reason that the loans be serviced post sale by a HUD-approved servicer.
Continue to provide for direct assignment and endorsement from FHA only to the bidding entity, and not to individual members of a bidding entity. During SF#2 a bidding entity requested that FHA execute powers of attorneys to individual members of a bidding entity, rather than just to the bidding entity as provided by the loan sale agreement, so that the individual members could execute assignments of mortgages and endorsements of notes directly to themselves rather than having to go through a two step process from FHA to the bidding entity then again to the members of bidding entity. FHA allowed this in a supplement under the theory that in this specific instance market competition would not be compromised.
During the market feedback process, one bidder requested that FHA specifically provide in the loan sale agreement for direct closing, or assignment and endorsement to individual members of a bidding entity. To allow this would be to invite the market to actively collude. That is, if no limits were placed on the number of bidders that FHA would close with or help assign and endorse notes to, in theory the entire market could divide up the loans and decide what they want to bid. Hence, a limit would have to be established. However, once you establish a limit you are favoring large bidders over small bidders to a substantial degree. That is, to the extent that several large bidders form a bidding entity, it takes less of them to achieve economies of scale than a group of small bidders. Hence, it is recommended the loan sale agreement not be changed, and this issue dealt with on a request by request basis.