Non-Performing Assets

Mon. Jul. 15, 2024

About Non-Performing Assets

This page is organized to provide you with information about non-performing assests and related concepts. Information presented here includes:

Non-Performing Assets Overview

In business and accounting, an Asset is defined as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction or event.

In simpler terms, an asset is a thing, usually something of value, and usually something you own.

On this web site we use a narrower definition, related to our business and the topics of this web site. For purposes of this web site, an Asset is a piece of real estate, or a lease, or a related financial obligation such as a Note and Security Instrument (Mortgage or Trust Deed), or a tax lien. These are both tangible and intangible assets, but they are all related to real estate.

All Assets can be classified as being on one of five basic stages:

  1. Performing,
  2. Performing, but Compromised
  3. Under-Performing
  4. Non-Performing
  5. Charge-Offs

Technically, any Asset that belongs to you, that is not doing what it is supposed to do, is a Non-Performing Asset (NPA). So if an Asset performs, it's doing what's expected. A simple analogy is Kindergarten. You lend someone your crayon, but they won't, or can't, give it back. They broke their promise. They did not perform.

Asset Related Definitions

We provide the following definitions for use in the context of this web site:

Performing. This is a loan or property (an Asset) that is making payments on time, and there are no problems or concerns.

Performing but Compromised. This is a loan or property (an Asset) that is making payments, and has a current balance. However it has been delinquent in the past, and there is a concern that the collateral or borrower is impaired. The collectibility of this Asset is less certain than a fully performing Asset, and the holder should have taken accordingly greater reserves.

Under-Performing. This is a loan or property (an Asset) that is making payments, but not on time and/or not in full. This Asset is in arrears, and the borrowers are struggling, making sporadic and/or partial payments. The borrower is exhibiting some degree of good faith, trying to make payments. The probability of fully collecting this Asset is even less certain than a Performing but Compromised Asset.

Non-Performing. This is a loan or property (an Asset) that is not making any payments. It is in arrears. The borrower is distressed. The collateral is worth less than the loan balance. The owners should have taken charges and reserves against these Assets. These loans must be sent to collection, properties must be seized and managed, and the costs associated with asset recovery are significant even before consideration of the diminished collateral value.

Charge-Offs. This is a loan or property (an Asset) that has been completely written off. The holder does not expect to recover anything. This is usually because the loan or property was foreclosed, and the borrower obtained a bankruptcy discharge. Other factors might include the property appraised for less than the outstanding loan balance after considering superior liens (more senior mortgages and/or tax liens) and costs of recovery. From an accounting standpoint, these are usually on the books for one dollar.

Assets that are under-performing, non-performing or charged off are basically divided into real estate or debts, and the debts can be further categorized as purchase money and tax liens, or judgments.

When a lender becomes the owner of real estate by foreclosure of a deed in lieu of foreclosure, it is called REO or OREO, which stands for Real Estate Owned, or Other Real Estate Owned. The lender typically sells REO as quickly as possible, to reduce liability and carrying costs.

When a lender or servicer holds loans that are non-performing, they are typically referred to as NPL (short for Non-Performing Loan) or a Supervised Loan.

Loans that have been written off are usually called Charge-Offs.

There are other types of financial obligations that encumber (liens on) real estate, including mechanics liens, property tax liens, and judgments against the property owner recorded in the county clerk's office.

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When the owner of real estate owns money to someone else, and they promise to repay the money, and they put up real estate as collateral for the debt, the person receiving the promise acquires a security interest in the property.

Normally, when you buy real estate, you don't pay all the money at closing. Very few people have that much money. So you borrow money from a bank (or other lender).

A document called a Note describes the indebtedness, and the terms of repayment. You secure your promise to repay them by giving them the right to sell your property in the event of a default. The document that conveys this security instrument is called a Mortgage or Deed of Trust, depending on the state.

Any debt can be secured by real estate. Loans made for the purpose of buying the same real estate that secures the loan is often called a Purchase Money Mortgage, which may have greater rights than other mortgages.

When there is more than one legal claim on a piece of real estate, either voluntarily by action of the owner, or involuntarily as a result of judgments, these claims will usually be paid in order. A description of this order is shown at Priority of Liens.

On this web site we use the term Mortgage generically referring to the debt (the Note) as well as the security instrument. We acknowledge the distinction, but use Mortgage generically for purposes of readability, and to confirm to the general public usage.

A more detailed description of mortgages is shown on our web page: Owners of Non Performing Mortgages.

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Tax Liens

A Tax Lien is a lien created by a taxing authority when the property owner does not pay the real estate taxes, or other charges and assessments in a timely manner. The Tax Lien, sometimes called a Tax Sale Certificate, or TSC, is recorded in the county clerk's land records, and becomes a new priority lien encumbering the property, often paramount to previously first mortgage liens.

Even with its super priority lien status, Tax Liens can become impaired or even worthless. However it is rare for a Tax Lien to achieve this dubious status except through negligence. If proper due diligence was undertaken before the Tax Lien Asset (TLA) was acquired, and if it was properly managed, then it should remain one of the safest secured investments available.

Since tax liens do not make payments to the holder, they are simply paid in full at some point, they are not classified based on their revenue flow. Rather, they are classified based on the value of the associated real estate collateralizing them, after deducting any paramount tax liens or other superior recorded security instruments, and on the bankruptcy status of the property owners.

So tax liens can also be Performing, Non-Performing or Charged-Off.

Judgments and other financial rights are similarly classified based on whether or not they are doing what was intended, and based on the value and status of the collateral and the obligor.

More information can be found at Owners of Non Performing Tax Liens

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When a debtor fails to repay a loan, and the lender institutes legal proceedings, the property is ultimately sold to raise money to repay the obligation.

Typically the lender (usually a bank) just wants to recover their money and their expenses. They don't want to become the owner of the property. However if the bank does become the owner of the property, either because the sales mechanism did not produce enough money to repay the loan, or if the borrower voluntarily conveyed the property to the bank to peacefully avoid a foreclosure, the bank calls this kind of real estate REO or OREO, which stands for Real Estate Owned or Other Real Estate Owned.

REO is a classification for properties owned by the bank after unsuccessfully trying to sell it at a public sale. After the bank becomes the owner, it tries to sell the property on its own. It usually cleans up the title and the physical property, and offers it to the market, typically via brokers.

Even in good times, banks prefer not to own such properties, because it creates a liability, it incurs expenses, and it represents capital that cannot be utilized for the banks main business, which is to lend money for a profit. In recessionary times where real estate values are falling, as they are presently, owning REO is especially undesirable because whatever value the bank hopes to salvage from the defaulted loan is going down in value.

Banks often sell REO to investors. Investors are hoping to get the property cheap. The investors usually plan to fix it up and then resell it for a profit. The banks are not in the business of renovating and managing properties, and they usually have higher overhead than investors, as well as needing to consider regulatory and accounting restrains.

In 2008 some banks have stopped foreclosing on delinquent mortgage loans because there are already so many vacant properties on the market that the bank does not expect they can sell the property, and they would rather keep the borrower in the property, so they will pay the utilities, and prevent the vandalism and decay that vacant properties are subject to.

Because owning real estate costs money, and the owner is responsible for its condition, banks prefer not to own REO.

Banks often sell delinquent mortgage loans, known as NPL, to investors, because the banks avoid the expense and uncertainty of the foreclosure process, and they avoid becoming the owner of many REO properties that they must then pay to insure, maintain and try to sell.

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A deed whereby one party conveys an interest to another, but the grantor does NOT make any promises or guarantees about the interest being conveyed, is often called a Quit Claim Deed or simply a quitclaim.

The grantor disclaims any interest in the property, and passes that claim to someone else (the grantee).

By comparison, the deeds usually used to convey real estate are called Grant Deeds or Warranty Deeds. These contain warranties and representations, promises that the grantor possesses certain rights or ownership interests, and these are what is conveyed to the grantee. Quitclaims are sometimes used for transfers between family members, or for special or unusual circumstances.

Of the different types of deeds, the quitclaim has the least assurance that the person receiving it will actually get any rights. In most common law jurisdictions, a quitclaim deed is not technically considered to be a deed at all, and, in some jurisdictions, a buyer who receives a quitclaim deed may not be considered a bona fide purchaser for value unless the quitclaim deed meets certain requirements.

A Quitclaim is considered to an estoppel, which means it estops or prevents the grantor from later claiming an interest in the property. A quitclaim does not release the grantor from their obligations under any mortgage or other lien secured against the property.

If you seek additional information about the various types of non-performing assets associated with Cherokee's business, we welcome your inquiry using our Contact Cherokee web page, or call Jay Wolfkind at (732) 741-2000.

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