Real Estate Owned is Trading Higher Than Notes

When it comes to dealing with the mortgage debt left over from the excesses of 2005-2007, a lot hangs on how government plans take shape. In the meantime, experts say the market for this often-securitized product has reached the point where real estate-owned in many cases trades better than notes and subprime loss estimates are increasing to the point where another downgrade of thousands of ratings could be seen.

"REO used to be at the bottom of the pricing spectrum. Now, however, and with few exceptions, REO packages are trading at a higher dollar price than even some mildly distressed note packages - something that has never happened," said Frank Pallotta, one of three former Wall Street executives serving as principals at the Rumson, N.J.-based Loan Value Group, an independent, third-party provider of advisory services aimed at helping clients assess, evaluate and manage residential mortgage risk.

"This is not a question of buyers feeling as though all loans will default, but rather absent a true source of liquidity at a reasonable market level; both buyers and sellers will stand down and discount cash flow to almost zero," said Mr. Pallotta.

He said cramdown legislation uncertainties in particular threaten private-label securitization market participants. "There is virtually no way to effectively price securities or loans with cramdown legislation in the air," he said. He alternately suggests alternatives that allow modifications even of non-delinquent loans without violating the language of securities' trusts when there is perceived imminent distress and he cautions that mods, which have had mixed success to date, might be more effective if they are carefully approached in practice on a case-by-case basis rather than in a "one size fits all" manner.

With these issues remaining uncertain, bulk REO packages have been trading but have declined in value from as high as 65% of broker price opinion dollar price to the low 40s to 50s because the properties "remain on the market longer, resulting in a dramatic decline in absolute values," although certain regional buyers still can offer some relatively favorable price compared to large national players. "Individual asset or very small bulk sales (through small, local real estate companies) have also dropped" and have been pegged at 70% to 75% of BPO value, he said.

When it comes to loans 30-plus days delinquent "virtually all paper ... is trading at lower levels than where the pure asset would trade ... which is unheard of," he said.

He said hundreds of California ZIP codes remain strongly bid as does the New York/New Jersey/Connecticut tri-state area but the ZIP codes' BPO values also have fallen to about 48%-56%.

In addition to all this, Moody's Investors Service has again increased its loss expectations for U.S. subprime residential mortgage-backed securities issued between 2005 and 2007, raising them to a range of 28% to 32% of the original pool balance from 22% and placing 7,942 tranches of subprime RMBS with an original balance of $680 billion on review for possible downgrade.

It said that ratings actions expected to occur as a result of this move make it likely that "mezzanine and subordinate certificates currently rated B or above would be downgraded to ratings of Caa or below, particularly for bonds issued in 2006 and 2007" while actions on senior bonds "will differ based on payment priority and protection relative to projected losses."

The rating agency added, however, that "given the losses currently being projected, a majority of senior certificates will likely be downgraded below investment grade" and "many are expected to be downgraded to Caa or below, particularly longer duration bonds" from '06/'07.

Moody's said the Homeowner Affordability and Stability Plan "is expected to have a mitigating impact." It added that while it already has formed a preliminary estimate of the impact of the plan and included that estimate in its numbers, that estimate could change when additional details of the plans are released.

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