The Case for Due Diligence
Mike DeSantis, President DeSigns Digital, LLC
Many of us are well aware of the value of performing due diligence on companies that we are considering doing business with. We are also comfortable with performing due diligence on loan portfolios that we are looking to acquire. These actions make perfect sense to us because we are actively seeking a relationship with a new counterparty and we want to ensure that we have all of our facts in order. Frankly, we want to cover our collective butts.
FAS 157 focuses on the price that we would receive to sell an asset or the price that we pay to transfer a liability, not the price that would be paid to acquire the asset or received to take on the liability. How do we determine this value?
The answer seems simple, you say. We do cash flow analysis on our portfolios. We look at comparable prices of loans. We know what our portfolios are worth!
True, you know what they are worth under laboratory conditions but are you getting the full picture? Have you determined if your collateral recording is proper? Do your cash flow models accurately predict delinquency and charge off based on empirical evidence contained in the origination files and not meaningless (in today’s environment) historical data? Despite all that you are doing, you have failed to answer the most basic question: What would an investor pay for this pool of loans in today’s market? The only way to determine this is to view the assets that you have on your books as if your firm were going to purchase them. In other words, you must perform due diligence on your own portfolios.
The process of reviewing your loan portfolio involves several layers. Of course, you must model current cash flows, something you are already doing. But there’s more to the process.
You must project delinquency and charge offs. Again, most of you are doing this but if you are simply using historical delinquency models and historical severity models you are missing key elements of the process, especially in the current economic environment. We are coming off years of historic lows in delinquency and charge off and replacing them with historic highs. Using historic models will not be sufficient in this market where we have seen both positive and negative peaks. You must look at the current state of risk through updated credit scores, re-verification of income sources, and validation of appraised values. In short, you must re-underwrite the loans to uncover any changes in the borrowers’ condition or to uncover flaws from the initial lending process.
During the re-underwriting process you must examine the quality assurance process of the original lender to ensure that no compliance issue will detract from the value of the individual loan in your portfolio. For example, an improperly handled rescission or incorrect TIL can severely impair the value of a loan in potential investors’ eyes.
You must verify that your liens are properly recorded and in the proper position. During the height of the refinance boom many mortgages and/or assignments went unrecorded due to the sheer volume of documents passing through recorders’ offices. Follow up was often difficult due to unusual delays at the recording offices making ticklers ineffective. By the time the back logs began easing at the recording offices, many lenders and servicers were in the process of downsizing their back offices effectively letting the recording deficiencies fall through the cracks. These flaws are often only uncovered at the point in which you want to exercise your rights to the collateral. This is not satisfactory. An investor would want assurances that the collateral is properly recorded and in the stated position. You do not want to find out that your collateral is improperly recorded by either failing to sell the asset or worse yet by being forced to buy back a potential loss months or years down the road. This can have a serious impact on your bottom line now and in the future and worse yet will be a totally unpredicted event in your future budget.
You must also understand the macro and micro market conditions that could affect the value of collateral. The old adage that all real estate markets are local is true but many ignore this simple concept by applying national trends to their analysis. This can be misleading at best and catastrophic at worst especially for creditors that are not acutely aware of the geographical dispersion of their portfolios.
Due diligence is not only for the owner or potential seller of loans, it can be a valuable tool for the debt buyer, as well. A pool of legally uncollectable loans is valueless at any price. Loans with compliance issues may cost more in remediation than they are worth. Speculating into a falling micro market will have serious negative consequences. Debt buyers also need to know what they are getting into. Some debt buyers are lured by seemingly low purchase prices and accept the bad with the good. Knowing the composition of a portfolio in detail can help the debt buyer refine the bid and allocate the servicing assets to maximize the return on the investment.
We live in a world of increasing scrutiny by regulators, auditors, senior management and, shareholders. The value of the assets we already own or that we are looking to buy will be a critical element in dealing with these stakeholders. Good valuation begins with good due diligence. Many are scared of the current market and because of this fear they are missing tremendous profit opportunities. In-depth knowledge of the assets we are looking at can remove the fear. Valuation of the assets will be necessary to satisfy these stakeholders but, more significantly, valuation of your assets will be necessary to remain competitive in portfolio sales, securitizations, or mergers and acquisitions.
About the Author
Mike DeSantis is President of DeSigns Digital, LLC. DeSigns Digital, LLC provides due diligence services, custom analytics, and custom software to the financial services industry. DeSigns Digital, LLC associates have experience in residential and consumer loan originations, servicing, purchases, and sales. In addition, the firm has subject matter experts in the areas of analytics, software development, and database management.