Note buyers?

Question

I know that note buyers buy notes.....but what does that mean?  what do they do with them once they have them? how do they make money? or what do they get out of it?

Jon Holdman · Answer

OK, Frank's correct that mortgages and bonds are the same thing. They're both loans.  So, do some reading on how bonds work, and you'll understand mortgages.

Briefly, though, a bond or mortgage is an agreement for someone to pay back a certain amount of money under certain terms.  Almost always, there's interest involved.  So, say Abe loans Barb $50,000 to be repaid monthly over 10 years at 10% interest. Payments are $660.75 per month.  After 10 years, 120 payments, Barb would pay back a total of $79,290.44.

Now, lets say that after one year Abe decides he would rather have the cash than the next nine years of payments.  Barb has been paying regularly.  The interest rate he could get today for the same loan, though, has fallen to 8%.  That makes his loan (or bond) more valuable than its face value.  That's what Frank means by the value of the loan/bond moving inversely with interest rates.

After one year, the face value (i.e., the remaining principle) of this loan is $46,932.91.  If someone made a loan of this amount, with payments of $660.75 per month for nine years, they would be getting 10% interest, exactly what Abe was getting.  But, interest rates have fallen.  So, if someone was making a new loan right now, they would only get 8%, and the payments would be correspondingly smaller for a $46,932.91 loan.  Barb's on the hook, though for the $660.75.  So, what's the value of the note (aka loan aka bond?)  We can back into by asking what's the principle amount that would result in payments of $660.75 for nine years at 8%.  That value is $50,753.14.  If you make a loan of $50,753.14 at 8% for nine years, the payments would be $660.75.  So, if Cal want's to buy Abe's note, he would need to pay $50,753.14.

If, on the other hand, interest rates when up, and a new note would now get 12% interest, Abe's note is worth corresponding less.  $43,515.78, to be exact.

Now, in the bond market that's pretty much how it works.

However, the relationship isn't perfect.  For one thing, you have to consider the quality of the borrower.  Here we assume that Barb is a good borrower, and is very likely to make the remaining 108 payments right on time.

If Barb had been a deadbeat, though, the story would be different.  If Barb was behind on the payments, and looked like she wasn't going to make the remaining payments, Cal might want a higher interest rate to account for the risk.  Whether current rates were 8%, 10%, or 12%, Cal might say, "I want 20% return to justify the risk."  Now, the value of the loan is only $32,993.96.

There's also a risk that the borrower will pay the loan off early (or "call the bond").  In that case, you would get the remaining principle amount, but not the interest you might have expected.

To go to your example, when you say you short a second mortgage, I think you mean you would buy it at a significant discount.  Given a value ($10,000 in your example), the payment amount, and the number of remaining payments, you can calculate the interest rate you're getting.  Without knowing the payment and number of payments left, I can't calculate it.  But it I guess something like the original example (10 year note, $100,000, 8%, sold after one year for $10,000), this note would be returning about 150% interest.

If you were to just plain buy the note from the current lienholder (this happens  all the time), you would continue to collect the payments from the original borrower.  Because you had paid more or less than the outstanding balance, you would be getting an adjusted interest rate on your money.  If you do this, then you have just become the bank.  This has no effect on the liens on the property.

It sounds like, though, you are thinking you could buy a note from a bank as part of doing a short sale.  Here you might be doing a short sale where the second has very little value because of declining property values.  So, you convince the second lienholder to sell you the note for $10K even though it was originally $100K.  Then, you either do a short on the first or you bring the first current and buy the house subject to.

Shorting the first would be easier because the second lien holder (you!) would be very cooperative.  You would be perfectly willing to get paid nothing when the sale occurred.  In that case, the $10K you paid for that note becomes part of your investment in the property.

If the first is now small enough that its a good deal to just take the property with that balance as the debt, a subject to might work.  Here, you would make the first current by paying the fees and back payments.  So, that's yet more money you put into the deal.  Now, you buy the house from the current owners subject to the existing first, and start making the payments.  So, in this case, your cash invested is the $10K, whatever you paid to bring the first current, and whatever you paid (if anything) directly to the owners.

Now, if you hold the second, you have one more option.  You could just go after the borrowers to pay you.  If they don't, you would be able to foreclose.  But, since its a second, a foreclosure would result in you getting it subject to the first.

If you had done a deal to buy the property, either via a short sale or a subject to, and then tried to go after the sellers to pay you off on the note they owe you, you would be subject to some righteous indignation from the sellers.

The only way you would get the $100K in your example (or, really, the current balance), would be in the borrowers paid it off.  In that case, its unlikely you would be able to get that huge discount.

Frank Adams · Answer

It sure does NOT remove the mortgage from the house! Why would you think that? The house is the only security for the $100K mortgage.

If you think you're going to buy a $100K mortgage for ten cents on the dollar, it probably isn't even worth that much.

Buying and selling notes is not for the timid or the uninformed. Spend some time studying the threads on this site, and take a finance course as I said earlier.

Frank

Jake Andersen · Answer

WOW! That's awesome.  Thanks for taking the time to explain that to me.  It certainly helps.  I have some idea of what is happening now. I am just referring to shorting the second to build equity in a short sale situation.  I would never go after the sellers, obviously, because it is them that I am trying to help.  You two have definitely helped me understand this much more clearly.  I only knew that I could short the second to build equity, but that I would have to buy it outright to have the lien removed from the property so that I could finish the short sale.  I thought that instead of me doing this that perhaps a note buyer could just take it off my hands since that is what they do.  But apparently that's NOT what they do.  I was wondering how someone could possibly make money holding a financial instrument that wasn't backed by anything and that nobody was paying on.  Now it makes sense.  because what I thought earlier certainly didn't.  Thank you for clearing that up gentlemen.  Alright, no more dumb questions! :D Cheers, jake

Jake Andersen · Answer

Thank you for your reply.  So essentially, If I short a $100,000 second mortgage and purchase it for say $10,000.  That takes the $100,000 lien off of the house AND I can continue to collect interest on that note?  Who pays the interest?  Or is there a way to cash that $100,000 in somewhere?  I'm slightly confused on this as you can tell but i'm trying to wrap my head around it.  Thanks for your help.

Frank Adams · Answer

They do with it what any other investor does with any other financial instrument; either keep it for the cash flow it provides, or resell it for a profit on the spread. I'd suggest you take a financial analysis course at a junior college or other. Pay particular attention to the part on BONDS, as a mortgage is essential a bond, ie; a fixed rate investment.

Typically the PRICE of a bond varies inversely with interest rates. That is if interest rates RISE, the price/value of a bond/mortgage will DROP because it is paying a fixed rate, that is below the prevailing market rate.

Frank