Dealing with Underwater Notes

13 Replies

So I've got a good handle on non-performing notes (2nds) that are both totally and partially covered by remaining equity in the house.   Does anyone deal with or know the approaches for no equity 2nds?  Seems like a great way to get wiped out, but I know PPR and some of the other funds are buying huge pools that include lots of these, so there must be a value to them (I guess at the right price, anything becomes profitable). I'd love to add and @Dave Van Horn and @Dion DePaoli, but I'm new and haven't figured that out yet. 

Thanks in advance. 

I received the tag Sean.  Dave certainly deals with more second liens than I do.  It is my understanding from ear to the ground a bit, there really is not that much happening in the secondary market regards to second liens.  I think there is some demand, but not product is really flowing in the market.  

All that said, no equity in second position is as you mention, risky.  In general, if that is the game plan a firm or investor wants to deploy, they likely need to arm themselves with the tools to do their jobs.  For instance, as we know, the second might become unsecured, so further pursuit of the debt can still take place but it will not be a secured collection attempt.  That might include getting a deficiency judgement and working the collection from that angle.  If you become unsecured, there is only so much you can do and there is no real magic to the approach.  

My opinion of the price parameters, to some extent, yes, there is a price for everything.  I would however, say he who puts that price down should really understand, and like above, have the tools to execute, the model which produced the price.  Again, if you do not have any equity, the collection process is a little different, it is still a collection process though.  As we could imagine, the recovery amounts will diminish and time will likely extend to recover that diminished amount.

When dealing with NP 2nds and the 1st mortgage is performing.    I treat all my deals the same,  equity position doesn't matter.   I start the FC process to put the pressure on the borrower and force them to deal with me. This will force the borrower to decide to pay me, give me the keys or file BK.   7 out of 10 will pay me to stay, no matter the equity.  The other 3, will be BK, short sale, sale or get actual possesion.   Most borrowers don't want to leave.   It's called emotional equity.   90% of my exits are through the borrower,  not the property.   I want a payment stream or payoff.  It's a game of numbers and statistics.   Lots of great deals in the NP 2nd space with no equity.   Just needs to be purchased at the right price.  This is the mind set of big funds dealing with NP 2nds with no equity.   Legal is a big tool to get the borrowers to pay, not really get the property.   It's a small percentage that you actually FC on and get the property.   

Thanks @Dion DePaoli & @Bill McCafferty, appreciate your insights.  Bill - I see the logic in what you're saying, but at this stage for me, just feels a bit too risky.  It this works out and I can start running with a handful of notes at one time, I'd love to start being able to think in terms of statistics and averages.  

Dion - is your ear to the ground hearing that there is a shortage of 2nds for sale or a shortage in interest the second notes generally?  I'm just starting out, but I'm finding a tough time finding many good notes to bid on (though there are definitely a small number that look interesting).  

Here is an article that addresses some of the secondary market activity of the liens:

Article Source Link

Legacy Second Liens, Once Short of Buyers, Now Lack Sellers BY BONNIE SINNOCK

AUG 15, 2014 10:44am ET

There was a time years ago when second liens were the toughest legacy home loan asset to find a buyer for in the secondary market.

But today, there aren't enough of these second liens being offered to match buyers' appetites — at least from the perspective of a limited group of fund managers who are looking to buy whole loan pools at a discount, said to Jonas Roth, managing director with MountainView Capital Group in Denver.

One would think those holding seconds would be happy to hear this, with particular nonperforming seconds in danger of becoming uncollectible under certain state laws.

But this motivation doesn't seem to be spurring enough sales to feed existing investor demand, although some deals do trade from time-to-time.

"Supply and demand are not coordinated right now," said Roth. "There are a few handfuls of buyers for both nonperforming and performing seconds who bid very competitively for the few deals that come to market."

Interestingly, although distressed product from the 2005 to 2007 housing boom and ensuing bust has been dwindling over time, the lack of trading supply stems less from a reduction in the outstanding inventory than some other barriers to sales today.

Roth said some banks still have "significant" amounts of nonperforming legacy loans in danger of going out of statute each month, but generally aren't selling them. This may be because they don't find the discount prices the paper sells for worth some of the associated counterparty and headline risk.

Funds have found nonbanks willing to sell, but there have been so many of these trades over the years that it's become difficult for them to get a discount that's high enough to deliver the returns promised to investors. Where they can't find seconds, some have invested in small pools of firsts.

Banks may not be selling because they've already marked down the value of these loans to zero. These write-downs generally occurred during the downturn, when seconds were often underwater and almost impossible to trade. Since then, home prices in many areas have started to recover.

Today, distressed, or once-distressed loans that are now reperforming, have been worth as much as 20 cents to 50 cents on the dollar on the secondary market, depending on the borrower's home equity and payment history, Roth said. That compares to a range of 55 cents to 80 cents on the dollar for seconds that have performed over the full life of the loan.

Nonperforming seconds have recently traded for 30 to 50 basis points, based on the unpaid principal balance of the loan. Once they go "out of statute," that amount drops to 10 or 15 basis points.

"There's still some value, but you now have a loan in many states that is not collectible," he said. "Buyers of these nonperforming seconds are looking for diamonds in the rough. They're looking for the few loans that are going to help them achieve their desired returns."

The fact that fund managers can usually only buy smaller pools outside of the bulk trades that banks typically engage in is another hurdle to bank sales. And counterparty risk is another concern.

"Some of the buyers of nonperforming seconds are companies that a lot of big banks with seconds just won't do business with," Roth said.

Counterparty reviews vary, ranging from extensive written requirements to merely verbal ones, but generally they are a hurdle. In one case, for example, "it is absolutely impossible to get counterparty approval for your new buyer because they just require so much information," he said.

Aggressive collection techniques used by some buyers also can be a concern for sellers if they feel the harm to the customer relationship or their reputation outweighs the gain from a distressed second lien sale.

A sample of lenders' first- and second-lien past dues based on unpaid principal balance from shows these are generally low today. (See related chart on 2.) So the recent new second lien boom doesn't help buyers of discount seconds who need product that has been marked down due to flaws or exceptions much.

Today's second liens are much more conservatively underwritten, relative to simultaneous second liens originated during the housing boom, said Suzanne Mistretta, a senior director at the New York-based Fitch Ratings. HELOCs, for example, aren't originated based only on the interest-only or initial teaser rate the way they were during the boom, but rather on full principal and interest payments.

All things being equal, a HELOC has an extra dimension of risk compared to closed-end seconds, so investors may pay less for the HELOC, said Frank Pallotta, the CEO of Ramsey, N.J.-based CMF Management Co. Pallotta is currently working on a Canadian mortgage finance project, but previously worked in the U.S. with distressed collateral and nonconforming securitizations. He still does some work advising banks related to legacy HELOCs, he said.

HELOC buyers not only have to consider whether the consumer has the wherewithal to pay the outstanding balance of the loan, but also whether they want to make other funds available to the borrower according to terms of the original note, Pallotta said.

There are concerns related to pending legacy HELOC resets as well, although some say these open-end second lien reset fears are overstated.

Reperforming and performing legacy seconds are the two areas where the limited group of loan buyers in these sectors seems more eager to buy recently, he said.

"Where you are seeing interest where interest didn't exist before is on reperforming loans, reperforming first liens and reperforming HELOCs. It's not screaming-through-the-roof interest, but it's definitely interest more than we saw a year ago," Pallotta said.

Legacy performing paper that have had high combined loan-to-value ratios, but borrowers who maintained a dependable payment history throughout the worst of the economic downturn, have been particularly popular, he added.

"The definite comeback has been what they call the 'perfect pays,' because I think you pay less attention to the CLTV and the fact that the loan has a 100% loss severity now, and you look at more with you know the borrower and that the borrower has wherewithal to make payments in prior, ugly years."

Prices for nonpeforming sectors are still very low compared to the performing and reperforming sectors, Pallotta said.

"You can get zero recovery, so those still trade at pennies on the dollar," said Pallotta. (One hundred basis points would be equal to a penny on a dollar.)

There are a lot of challenges when it comes to legacy second workouts with performance issues, since by definition, the loans have a secondary claim relative to the first lien, said Robert Shiller, a senior vice president at special servicer Wingspan Portfolio Advisors.

It's difficult to say how many seconds from 2005 to 2007 are passing the point where they are collectible, because state-level statutes of limitations on debt collection vary greatly and have many nuances. But generally, the time limit can range from five to 10 years, starting when borrower payments first falter. Anecdotally, Shiller said he is currently seeing some 2005 product go through this transition.

Buyers may still pay a small amount for these loans even when they are past the deadline, as sometimes there are still ways to collect, though in other cases, it's extremely unlikely, said Shiller. For example, some states ban litigation, but not collections after the deadline, while other states ban both collections and litigation.

Banks are wary of counterparty risk hurting their customer relationships as some collections efforts do pursue widespread litigation against second-lien borrowers, particularly if the investor involved is buying in bulk. There are alternatives such as profit-splitting joint ventures with servicers where collections efforts are more customer-friendly and selective, said Shiller. Borrowers may be willing to arrive at compromises that help their credit, such as modifications, if they are not yet at the foreclosure stage.

"You have to understand who you're selling your loans to," he said.

Worth reading:

You can get a good explanation of the "emotional equity" theory read Gordon Moss' book, 

Performance Anxiety

Just like in any business, if someone doesn't actually do it and make money at it, you may want to give ear to the ones that do.  @Bill McCafferty, who I know, and have worked with on some notes is banging it out all day, everyday.  Dave VanHorn, who taught me and my friends the business, is a national speaker and highly respected in this arena and he has built that all on 2nds.  He is only recently entering 1sts because if there is money to be made, then make it.  If you know how to buy and how to exit through the borrower, you will do very very well.  

Thanks Marty, 

I'm about to give it a go on my first note... Thanks for the encouragement.  Looked at all of Dave at PPR's videos and they've been very helpful. 


Hi @Sean M.  

Sorry that it took me so long to get back to you on this thread, as I was on vacation for a week (@Rick H.   – I was actually out your way).

You are correct that no-equity 2nds can be riskier than equity-backed 2nds on a loan level basis. But, it is also a risk-reward equation. We buy mostly no-equity seconds, at lower price points with a higher potential for upside, and this is actually where we make the bulk of our revenue in today’s market. But, we do buy both and we purchase first liens as well.

I understand your line of questioning, as we also thought it was too risky when we were getting started in the business. We started out only buying notes fully covered by equity. When the housing market crashed and home values dropped, our pool of equity deals suddenly had no-equity, but we were able to exit close to the same number of deals. Fortunately, we were able to capture that data, and we were able to determine that we could purchase cheaper, no-equity seconds, and we could still exit close to the same number of deals.

To @Bill McCafferty 's  point, our view is similar; we do pretty much treat all of our deals the same for the asset class of senior performing. Equity isn’t a huge differential for us either, in most cases, although our recoverable is more favorable and quicker with equity deals.

We find that the extremely upside-down assets can vary a little from what Bill is saying. For example, if a property is not under-water and a homeowner understands that their lender would make money if they were to foreclose, the homeowner may call in quicker and work out agreements may happen sooner. When it’s the opposite situation, the process may be delayed.

I’m glad Bill touched on Emotional Equity, because this is a key component. With regard to approaches, it’s much more common with seconds (equity or no-equity) to exit through involvement with the borrower (i.e. payment plan, discounted payoff, cash for keys, seller-assist, short sales, etc.), than through the property (foreclosure). In today’s market, we don’t see many deed in lieu situations with seconds. With first liens, we also see more REOs.

If you have more deals, wiped liens are less of a threat. Purchasing no-equity seconds does enable us to spread more capital among more deals and have greater diversification in numbers. This is similar to what you’d see in real estate when an investor buys a duplex or a triplex instead of a single family house, because they’re thinking about what would happen if a tenant moves.

I agree with @Dion DePaoli that major banks haven’t released tons of seconds recently, and this may have a lot to do with the new regulations enforced by the CFPB.

The trading of seconds in the secondary market, from what I’ve seen, has always been more sporadic than firsts, due to the smaller size of the seconds’ market. That being said, we’ve still been able to purchase more quality assets this year than we did all of last year.

I hope some of this info helps!



My contact at Wells Fargo told me they are getting ready to release some of their 1st non-performing notes to the Gaylords very soon.

Joe Gore

Originally posted by @Joe Gore:

My contact at Wells Fargo told me they are getting ready to release some of their 1st non-performing notes to the Gaylords very soon.

Joe Gore

 "Gaylords" - the oldest street gang in Chicago?  

Interesting, didn't know they were in the business.

@Dion DePaoli,

Only people in real estate would know who the Gaylords are.

Joe Gore

Thanks everyone for your comments - much appreciated. 

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