Scratch-and-Dent Loan Market Offers Outlet

MBA (4/9/2008 ) Palaparty, Vijay
While scratch-and-dent loans accumulate and restrict cash, loan sellers now have the option of turning to an emerging market of loan buyers who offer liquidation. Sale of such loans provides refinance or resale opportunities, sometimes also ending in foreclosure.
“What drives the scratch and dent market is the seller of the loan who has a need for liquidity; otherwise the seller would not sell the loan at a discount,” said Jon Daurio, chairman and CEO of Kondaur Capital Corp., Santa Ana, Calif.

Daurio said a loan is scratch-and-dent for any of the following three reasons: loan performance —the loan is either in default or was previously in default; a loan where a regulation was violated in the origination process; or for underwriting reasons that involve fraud.

Companies such as Kondaur Capital have entered the market, buying loans at huge discounts with the potential of repackaging and selling the loans.

“The process involves high-touch due diligence management,” Daurio said. “We might refinance or restructure the loans or we may resell them. If it’s a nonperforming loan, we may get a died-in-lieu. What we do is characterize borrowers as those who have the ability and desire to pay and stay, those who should sell and go, and those who do nothing.”

Daurio said that loan attributes play a significant part in purchasing decisions. From a due diligence perspective, the company conducts a two week to four week review of the loans to verify accuracy.

“In the scratch and dent world, most sellers don’t have accurate information and many times the information is off,” Daurio said. “Factors such as the status of the loan, unpaid balance and collateral values information result in us adjusting our price. Regardless, sellers should be figuring out what is a fair and reasonable amount for these loans.”

As homeownership preservation efforts makes headlines, the scratch-and-dent market could make additional progress. “It’s a win-win situation,” Daurio said. “In the event that we may have to foreclose on a home, it's usually after we make every other effort to keep the borrower in the home. More often than not, the reason is because we can’t reach the borrower at all.”

“The incredible magnitude of repurchase obligations has led to a liquidity crisis in the mortgage banking industry,” Daurio said. “Loan sellers typically do not have sufficient cash to repurchase the loans nor the ability to borrow sufficient cash. As a result, a scratch-and-dent loan buyers will arrange with the loan seller to buy the loan from the loan buyer at less than par, with the loan seller making up the difference. Such differences can and likely will, in the aggregate, amount to billions of dollars.”