A company that has been helping to mitigate strategic default risk with borrower incentives for on-time payments, now is more broadly offering to help clients mitigate certain second-lien loan balance sheet concerns through rewards for accelerated pay-downs.
“We came up with a strategy to help banks reduce their second lien exposure by offering rewards to the borrower,” Loan Value Group managing partner Frank Pallotta told this publication.
The company has found in providing large-scale management and tracking of these second-lien accelerated payment rewards over a recent five-month period that almost one-third of those who enroll in the program have begun to accelerate their payments.
LVG originally created the program while working with a “large Southeast bank,” Pallotta said, noting that confidentiality agreements currently constrain him from more specifically naming clients. He said some other banks and at least one hedge fund investor also have used the strategy.
Pay-downs can be attractive to second-lien holders, in particular banks who have to record them on their balance sheets using mark-to-market accounting, because they can be riskier assets and have been selling at relatively low prices.
“You reduce your [problematic] second lien exposure in really two ways: you try and sell it or you try to get it to pay down,” explained Pallotta. “But in a lot of these cases, spotty second lien loans are trading at 5 or 8 cents on the dollar or as low as 2 cents on the dollar.”
This has made paying matching rewards to borrowers that have averaged 100% of the accelerated payment attractive relative to selling off the asset. (Even at a rate of one-for-one matching, the bank is still selling the loan back to the borrower at 50 cents on the dollar.) Percentages have been based on risk factors such as loan-to-value ratio, depreciation risk in a region and whether the property is owner-occupied.
Given this relative value, Pallotta said, “Why not put the borrowers in a situation where they can help buy down their own debt?”
Borrowers have been either paid the incentives in the form of cash at the end of the loan's term or through accumulation of matched funds applied at the point where there are enough to extinguish the loan, he said.
The practice also could be applied to first-liens but has not to date because of the larger amounts involved, said Pallotta.
