Smaller, thinly capitalized investors in nonperforming mortgages could face liquidity concerns in the coming months as private equity investors begin to re-examine their commitment to the business while bolting for higher returns elsewhere.

No one is predicting a massive exodus of PE money from the sector quite yet, but industry veterans believe the business could soon bifurcate with larger NPL firms (with proven track records) holding steady, while smaller players find it harder to get backing.

“This is all about 'the trade,’” said a Midwestern-based NPL executive, requesting anonymity. The problem, he noted, isn’t the returns in the business are poor — it’s a matter of yield. “You can get an IRR (internal rate of return) of 13% on this business still, but some of these funds are saying that’s not good enough anymore — they can make 20% by trading currency.”

In other words, the risk/reward on other investments, be it commodities or stocks, are starting to look better.

To date, the highest profile exit from the NPL space came about a year ago when Marathon Asset Management, New York, a hedge fund, pulled the plug on its fund and liquidated its residential holdings as well as a servicing affiliate.

In recent interviews, investors and managers alike continued to complain about both a lack of available product and the spread between the “bid” and the “ask” price of distressed loans. The gripe is consistent: that banks have plenty of nonperforming loans to sell but they won’t let go of them at a price that NPL investors like. (One loan trader estimated that of all the NPL deals offered over the past two years, just 7% ever closed. “Seven out of 100,” he said. “It’s the bid/ask.”)

Last month, Kondaur Capital, Orange, Calif., slashed almost 40% of its workforce (155 full-timers), citing a lack of available product to buy. But then again, that hasn’t stopped the firm’s president Jon Daurio from trying. Just last week Kondaur hired a new executive whose sole job will be to beat the bushes at community lenders, convincing them to sell their NPLs.

Just prior to announcing the hiring of the executive, Mark Ferrara, Kondaur found out that it was the winning bidder on a 1,000-loan NPL pool offered by the Department of Housing and Urban Development.

The new loans brings Kondaur’s NPL portfolio up to 4,000 units but because the firm liquidates roughly 10% of its holdings each month it must continue to feed the machine, which is why it hired Ferrara. (Once it buys a loan it moves to cure the note either through a deed-in-lieu or a foreclosure.)

In other words, it appears that Kondaur, instead of relying solely on auctions, is being proactive by hiring someone to knock on doors. But will it work? Some NPL investors say they’ve tried the “knock on the door” approach and it hasn’t succeeded.

One mortgage executive, who manages a firm that services roughly $90 million in distressed loans, said he knows of competitors that are scrambling. “My 'wheel house’ is buying one to 15 loans and I’ve approached credit unions and community banks. They don’t want to part with them,” he said. “I’ve tried. They think this stuff is worth 80 [of the broker price opinion or BPO] and I will tell you that it’s not. I’ll offer 60 but they continue to turn their noses up.”

This executive, too, did not want his name published, a common request of many in the sector who talk to the media. Daurio, along with Don Cogsville of The Cogsville Group, New York, are among the exceptions.

Cogsville, though, has a focus on commercial real estate and loans, and is a bit more optimistic when it comes to his outlook. He sees plenty of opportunity — and product.

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