Scratched Loan
Also known as: scratched loan, scratch, scratched asset, pulled loan
Scratched loan refers to a loan that is removed from a loan pool transaction before closing, typically because due diligence uncovered issues that make the individual asset unacceptable to the buyer. Scratching is a normal and expected part of pool transactions — no seller guarantees that every loan in a pool will survive buyer review. The process protects buyers from acquiring assets with fundamental defects while giving sellers a mechanism to close the overall deal despite individual problem loans.
Common Reasons Loans Get Scratched
During the due diligence window, a buyer reviews each loan's collateral file, title history, property condition, and data accuracy. Issues that frequently lead to a scratch include:
- Missing or defective collateral documents. The original promissory note is missing, the mortgage or deed of trust was never recorded, or the allonge chain is incomplete.
- Title defects. The chain of title shows breaks in the assignment history, unreleased prior liens, or competing ownership claims that would require a quiet title action to resolve.
- Material data discrepancies. The tape shows a $100,000 unpaid principal balance, but the actual loan documents reflect $65,000. Or the tape lists the property as owner-occupied, but research shows it has been vacant for three years.
- Property condition. The property has been demolished, condemned, or is in such poor condition that the collateral value does not support the investment thesis.
- Active litigation. The loan is involved in a pending lawsuit — bankruptcy adversary proceeding, borrower counterclaim, or servicer dispute — that materially changes the risk profile.
- Regulatory red flags. The loan has TILA/RESPA violations, predatory lending characteristics, or other compliance issues that create legal liability for the new note holder.
How Scratches Work in the LPSA
The loan purchase sale agreement (LPSA) governs the mechanics of scratching loans. Key provisions to understand:
| LPSA Provision | What It Means |
|---|---|
| Scratch deadline | The date by which the buyer must submit their scratch list — typically aligned with the end of the due diligence period |
| Scratch cap | The maximum number or percentage of loans the buyer can remove (e.g., 10-20% of the pool by count or balance) |
| Seller termination right | If scratches exceed the cap, the seller may have the right to terminate the entire transaction |
| Price adjustment | The total purchase price is reduced by the allocated value of each scratched loan |
| Substitution right | Some LPSAs allow the seller to substitute replacement loans for scratched assets rather than reducing the pool size |
Buyers should negotiate scratch provisions carefully before signing the LPSA. A tight scratch cap or short due diligence window limits your ability to remove problem loans, while an overly generous cap may make the seller hesitant to award you the deal.
Strategic Considerations for Buyers
Scratching is not just a defensive move — it is a strategic tool that affects your portfolio composition and returns:
- Scratch the worst, keep the best. The primary purpose of scratching is quality control. Removing the bottom 10-15% of a pool by risk profile can significantly improve the overall portfolio performance.
- Do not over-scratch. Removing too many loans signals to the seller that you are either an inexperienced buyer or excessively conservative. Sellers track scratch rates by buyer, and a reputation for aggressive scratching can get you cut from future tape distributions.
- Factor scratch expectations into pricing. If you expect to scratch 10% of a pool, your bid should reflect the economics of the remaining 90%. Bidding as if you will keep all 100 loans and then scratching 15 of them changes the deal economics — sometimes for the better, sometimes not.
- Prioritize scratches by impact. With a limited scratch budget, focus on loans with the most damaging issues: missing notes (hard to enforce), broken title chains (expensive to fix), and material data errors (the entire investment thesis is wrong).
What Happens to Scratched Loans
Scratched loans do not disappear — they cycle back into the market. The seller may include them in the next pool offering, sell them individually through a broker, or bundle multiple scratched assets from different deals into a "scratch and dent" tape. These secondary offerings can actually be a sourcing opportunity for experienced investors who are comfortable working through the specific issues that caused the initial buyer to pass. A loan scratched for a missing allonge, for example, might be resolvable with a lost note affidavit — turning another buyer's scratch into your discounted acquisition.
Understanding the scratch process is essential for any investor participating in loan pool transactions. It protects your capital on the defensive side and shapes your portfolio quality on the offensive side — making it one of the most important levers you control between bid acceptance and closing.
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