First things first... Happy New Year everyone! I hope your 2015 is off to a good start.
I have a hypothetical scenario for you to ponder. Let's say you are looking at purchasing a performing note, but after doing that math on the note terms you realize that the payment called out in the note is a bit higher than it should be. The P&I payment the borrower has been paying since 2009 translates to a rate .05% higher than the rate called out on the note. The note term is 25 years, so there is plenty of UPB remaining.
This is clearly not a great situation for the note purchaser but lets say for sake of argument that we are getting a very nice discount on the note so we are inclined to try to make the deal work. Let's also say that the borrower has no idea there is an error and neither does the seller but you, the purchaser, are an ethical and honest business person so if you purchase the note you want to fix the issue rather than bury them.
So the question is, what would you do in this situation? Would you walk away? If not, how would you try to work with both the seller and the borrower? What potential legal liabilities do you see here?
My rate discrepancy was supposed to be .5%, not .05%.
I see no reason to walk away if the seller can fix things with the borrower. If they can great, if not you can walk latter.
Too, does the note specify the payment amount? If the calculated amount is off but the note states that the payment is $xxx.yy and they have been paying that it may be questionable as to what one governs.
There should be a way to make this a win win for the note holder (hopefully you) and the borrower. Recalculate the payments and forgive a few at the end, or the next payment, recalculate the balance due after applying the extra to principle.
Look for a win / win on the deal. Any time you solve a problem you are adding value.
Have the seller correct the error (with the knowledge of the payor) and then buy the note. As far as liability. would you have any if you have full agreement of the payor and note holder and they sing off on such?
I am sure your scenario happens many times in real life. Good question.
I have seen this many times. Mostly as a result of modification but a couple in origination. There is zero reason to walk away from this and I would add I would not really "feel" bad an error is an error unless it was intended and most of the time these situations are not intended to take place. I am not inclined as a Buyer to share any discoveries such as this with a Seller unless the error would cause a greater discount that needs some explanation. I do not need a Seller to fix this as I would want to make sure it is done correctly and to my liking. So with a correct yield calculation you make your bid and buy the asset and then deal with the error. Due diligence needs to look to the history and origin of the error to understand what steps you need to take on the account to correct the ship. Like I said no need to alert the Seller IMO, and more than likely this is not likely an error which would cause the already present discount (assumed) to greatly increase.
I would double check your assumption by looking to the current balance and where it should be in the amortization of the loan. The payment should be resulting in prepayment. A faster reduction of principal. (advantage to note buyer with slightly more equity!) If the prepayment is not being properly applied to the account a balance correction to favor the borrower will need to take place. Any correction to a Borrower's account which is a net benefit to the borrower can take place with minimal interaction of the borrower. In other words, just make the correction and move on. It is always nice to get a pat on the back from the Borrower but sometimes stepping into the light can backfire on you.
It may be relative to understand if the error caused any incorrect applications of late fees. Depending on the note language a late fee may be a set amount or a percent of the payment. So if they have been using the payment which is in excess the late fee amount would also have excess. Not to mention any partial payments or payments held in suspense. Take steps to ensure the borrower gets credit as needed.
To speak to due diligence just a tad more. It is not overly unusual for a servicer to be handling this properly already. So I would not jump to conclusions without reviewing a payment history from the servicer. Obviously if this loan is an ARM the error would have a bit more of an impact and require a greater correction. Sometimes a servicer will aggregate the prepayment in suspense before applying a full payment. In example, if the general overage is $50 and the payment properly due is $500 then after ten payments the servicer will apply one full payment and the borrower will be ahead one period. The amount can also be applied on a per period basis as the payment is made and applied. Both methods are fine.
Thanks for your responses on this. I have seen this a number of times reviewing assets but have never actually purchased one of them. I am looking at another one now, which prompted me to tap the BP brain trust.
@Bob E. Yes, the note specifies the payment amount, and the payment amount is incorrect (overstated) based on the other terms cited; rate, number of payments, and original balance. Aside from being a pain at the moment, I agree that this could potentially be a win/win scenario for buyer and borrower.
@Dion DePaoli I think you hit the nail on the head here. In this case, because the borrower has been making larger payments than necessary, the buyer must scrutinize the payment history and be assured that the overage was properly applied to principal. The late charges must also be scrutinized. If the accounting was improperly done at the servicing end the UPB could be overstated. Informing the seller, of course, would be a decision based on whether or not the issue favors seller or buyer. In this case it may be neutral, or it could favor the seller if UPB is overstated. (This purchase based on % of UPB.)
@Boyd McClean I like your idea of having the seller fix the issue prior to purchase. On the other hand it could open a can or worms with the borrower. My thinking is that a note like this is not suitable for sale to passive note investors who are not working with notes on a professional basis. If the note is intended as a long term hold, then it might be fine to let it ride as is and simply make sure the accounting is done properly at the servicer.
Follow-up Question: Assuming a fix is needed, what would that look like? I am thinking one component of it could be an addendum to the note. Another aspect could be an account statement from the servicer which would include UPB and payment amount. Thoughts?
For what it is worth, I would say do not make more of this than it is not. It's an error. Its not uncommon. I am guessing with the term mentioned it has not really affected much. There is a flavor of this being thought of as more of a defect than it actually is. For no better way to say it, ultimately this is not that big of deal. Just correct it and move on.
If this loan was closer to maturity then the issue would have a greater impact since a larger impact on yield to maturity would be a greater concern. That does not sound like the case here. Errors happen. They can be identified by the servicer, borrower or investor. As long as they are dealt with once discovered not that big of a deal.
As I mentioned, the resolution here is ensure the borrower account is properly accounted for. If it is not, then have your servicer make the required corrections to credit the borrowers account. Any action on a borrower account which is a net benefit to the borrower does not require the borrower to be involved. Your servicer should know how to handle all this.
Ultimately, the treatment of the payment is more important than the number on the note or modification agreement here. What is due becomes relative to how it is applied to the account. The account statement can serve as notice or if your servicer wants to send a letter they can do that too. The letter can be saved to file for future reference. Chances are your servicer will send some form of communication so they have it in file for any loan audits they may experience in the future. Chances are they may bet bonus points for be preemptive in dealing with the issue.
This is not an overly involved task. Once it is done, it's done forever. (passive not passive is irrelevant in that sense)
Addendum to Note: No - the note terms are not really changing they are being applied properly. Also, the note is already established the only way to change it formally is through a modification. This does not warrant any such action.
Payment is a function of rate, term and amount. Rate is not a function of payment.
@Dion DePaoli Thanks for the additional insight here. I imagine that handling something like this is not a new thing for an established servicer.
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