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The "scratch and dent" mortgage loan market evolved in the late 1980s with the S&L bailout and the subsequent liquidation of thrift assets. Today, bank regulators and liquidity concerns put significant pressure on banks and non-banks to reduce exposure to non-performing assets. As a result, over the past decade we have seen the continued growth and development of the scratch and dent market, though many investors may not understand the nuances of this asset class.
Scratch and dent mortgage loans are as they are defined, mortgage loans that are "scratched" and "dented." Specifically, scratch and dent mortgage loans fall outside of the customary A, Alt. A, or subprime originator guidelines and performance expectations. There are numerous reasons for a mortgage loan to be considered a scratch and dent loan. These reasons range from simple (i.e., unusual loan terms, missing documentation, or other non-serious underwriting exceptions) to serious (i.e., first-payment defaults, poor payment history, poor appraisal quality, or compliance issues). While the majority of scratch and dent loans are performing loans, they also may be either 1) re-performing, 2) non-performing, or 3) sub-performing:
* Re-performing loans at one point were seriously delinquent, but now show a consistent payment history and have been modified to become current.
* Non-performing loans are now seriously delinquent and are expected to result in liquidation.
* Sub-performing loans are also seriously delinquent, but it is still unclear whether they will eventually be reperforming or non-performing.
Typically, originators sell their scratch and dent mortgage loans to buyers who specialize in servicing and collection of scratch and dent mortgage loans. Today, those buyers customarily finance the loans in securitization transactions through vehicles such as revolving trusts, REMICs, commercial paper facilities, and liquidating trusts. Some of the key issuers in this area include C-BASS, GMAC-RFC, Countrywide, and Option One.
This article considers three areas an investor should understand when participating in a securitization transaction involving scratch and dent mortgage loans: acquisitions, servicing, and structure. In comparison to other commodity type assets, the performance of a scratch and dent mortgage loan pool, and thus the value of such pool, is to a much greater degree dependent on the securitization seller and the servicer and their skill and ability.
ACQUISITION BY SECURITIZATION SELLER
Purchasing scratch...