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Hedge Funds See Cheap Homes With Soured Loans: Mortgages

Photographer: Daniel Acker/Bloomberg

A home for sale in Spring Valley, on June 7, 2013. One William Street joins other investors targeting the soured home loans after property prices jumped. Close

A home for sale in Spring Valley, on June 7, 2013. One William Street joins other... Read More

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Photographer: Daniel Acker/Bloomberg

A home for sale in Spring Valley, on June 7, 2013. One William Street joins other investors targeting the soured home loans after property prices jumped.

After David Sherr left Lehman Brothers Holdings Inc. in 2007 to start a hedge fund, he considered buying delinquent mortgages to profit from the U.S. housing collapse. Following years of passing on the debt, he now sees the loans as one of the best ways to play the recovery.

Sherr’s One William Street Capital Management LP, a $2.7 billion investment firm, is starting a fund to buy non-performing loans, or NPLs, tied to delinquent borrowers who haven’t yet lost their homes to foreclosure, according to a letter to investors obtained by Bloomberg. NPLs are selling at 60 percent to 80 percent of estimated property values, the letter said, offering the “cleanest exposure” to housing.

Slideshow: Where Higher Rates Could Hurt Home Buyers Most

One William Street joins investors including Ellington Management Group LLC and Starwood Property Trust Inc. (STWD) targeting the soured home loans after property prices jumped 24 percent from the 2012 trough and foreclosures dropped to the lowest level since 2007. Sales of the debt are poised to increase as banks face new regulations that make it more expensive to hold the loans, and the government auctions mortgages to help avert foreclosures and stem losses at the financially troubled Federal Housing Administration.

“The supply of NPLs is going to be very substantial for the next several years,” said Michael Vranos, Chief Executive Officer of Ellington, which oversees $6 billion. “Until last year, with the heavy supply of distressed securities, but only light supply of NPLs, we saw much better value in securities.”

Ellington Prediction

Ellington hired former Credit Suisse Group AG managing director Patrick Dodman in April to trade non-performing loans. The Old Greenwich, Connecticut-based firm forecasts transactions will exceed last year’s $25 billion. The U.S. Department of Housing and Urban Development, which has sold at least 50,000 non-performing single-family loans insured by the FHA since 2010, is planning further auctions this year.

HUD offers the loans at a significant discount to the unpaid principal balance with the expectation that buyers will try to modify the loan terms or take other actions to prevent neighborhoods from being swamped with vacant homes. Homeowners have a better chance of keeping their properties if the loans are sold because FHA’s rules prevent borrower-aid tactics available to private investors, such as reductions to principal balances.

Winners of an auction in December include Bayview Financial LP, backed by Blackstone Group LP (BX) and mortgage-bond pioneer Lewis Ranieri’s Selene Investment Partners, HUD disclosures show. Buyers paid an average of 52 percent of the $2.6 billion loan balances, or 69 percent of the estimated property values.

Citigroup Sales

Other sellers include some of the country’s largest banks. Citigroup Inc. (C) had about $4.6 billion in North American mortgages with late payments at the end of 2013, according to the New York-based lender. The loans, which aren’t guaranteed by the government, are part of a group of unwanted assets the bank plans to sell. Shannon Bell, a bank spokeswoman, declined to comment.

There are about 1.3 million properties in the U.S. tied to loans at least 90 days late and not yet in foreclosure, according to Black Knight Financial Services. Another 4.5 million borrowers are at least 30 days delinquent or in the repossession process, according to a report released today.

Investors are seeking alternative bets on housing after subprime-mortgage bond prices jumped about 17 percent last year and property prices surged by the most since 2006. Home prices in 20 U.S. cities rose 13.7 percent in November from a year ago, according to the S&P/Case-Shiller index.

Home Prices

Values increased as the economy strengthened and firms led by Blackstone bought more than 366,200 single-family homes in cities such as Phoenix and Atlanta since January 2011 to turn into rentals, according to Port Street Realty and RealtyTrac data. That’s made delinquent loans a relatively cheaper way to acquire real estate or profit by working with borrowers who are behind on mortgage payments.

Sherr started One William Street in 2007 after a 21-year career at Lehman, culminating in heading the bank’s securitization group. He named the investment firm after the former address of Lehman’s headquarters in New York with plans to buy mortgages, credit-default swaps and other bonds.

While following and being involved in the NPL market since 2008, One William Street chose to “de-emphasize them,” according to the investor letter. That changed at the end of 2012, when the firm started purchasing packages of loans from HUD. It also financed a block of the delinquent loans through parceling the debt into new bonds, lifting expected returns from the “high single-digits to low double-digits,” the investor letter said.

Mickey Mandelbaum, a spokesman for One William Street at Muirfield Partners, declined to comment.

Rental Properties

Ellington considers delinquent loans as one of the biggest opportunities this year, said Vranos. The firm weighs buying soured debt or foreclosed homes to turn into rentals depending on the location.

“There are certain areas where we may might want to buy a house, where we may not be able to necessarily get the NPL,” said Vranos, who founded Ellington in 1994. The firm expects to see strong home price appreciation continue in several parts of Florida, including Punta Gorda and Miami, as well as Las Vegas.

Ashish Pandey, CEO of Altisource Residential Corp. (RESI), said at a conference in Las Vegas last week that he expects as many as 500,000 non-performing loans to sell in 2014.

“Banks have made a decision internally that a delinquent borrower is not a core customer,” said Pandey, whose firm had 6,300 delinquent loans as of the third quarter of 2013. Altisource rose 0.6 percent to $30.67 today, and has gained 94 percent since 2012.

“There’s also headline risks, so for banks, it makes sense to sell,” Pandey said.

To contact the reporters on this story: Heather Perlberg in New York at hperlberg@bloomberg.net; Kelly Bit in New York at kbit@bloomberg.net

To contact the editors responsible for this story: Rob Urban at robprag@bloomberg.net; Christian Baumgaertel at cbaumgaertel@bloomberg.net

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