Best way to deal with an Underwater Mortgage
Barstow, CA · Member since 2013 · 51 posts · 7 votes
Best way to deal with an Underwater Mortgage
17 Replies
I am a seasoned note investor - real and personal.
I do not mean any disrespect, but only want to protect you from yourself.
Please do not buy a single note until you have more knowledge on the subject. There is a whole lot more to learn than you can read on a blog or in a book or two. Beyond learning about notes and their construction, you also need to thoroughly learn the finance laws - from federal to state - there are many. Understand the laws and the reason behind the laws.
If possible, become associated with a seasoned note buyer/seller. Not as good, but also valuable, become associated with a mortgage brokerage company.
By doing all of these ideas, you will then know the answer to your question.
- Barstow, CA · Member since 2013 · 51 posts · 7 votes13y
No disrespect taken, and I appreciate you responding to my post, the question was spawn through research that I had performed. And you hit the nail on the in-regards to blogs, books.
I believe the best course of action is to align myself with a seasoned note buyer/seller which is something I'm currently working on.
Any advice on how to approach a seasoned investor?
Thanks Tom
- Specialist · Westlake Village, CA · Member since 2010 · 1k+ posts · 781 votes13y
It's all about the collateral
Whether it is performing or not doesn't really matter to me initially.
If you are looking to buy a note secured by a first Trust Deed on a property.
Look at the as is net liquidation value of the property first minus any superior liens (property taxes etc.) and liquidation costs etc.
I buy underwater mortgages all the time but at the appropriate discount.
- Barstow, CA · Member since 2013 · 51 posts · 7 votes13y
Thanks for chiming in!
So the fact the mortgage is underwater is not a underlining factor, got it, and it is more about the collateral.
Thanks all!
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
Originally posted by Ron Kelley:
@Ellis San Jose
Thanks for chiming in!
So the fact the mortgage is underwater is not a underlining factor, got it, and it is more about the collateral.
Thanks all!
This simply is not true. The fact the mortgage is upside down is a major factor. It changes the disposition.
When a mortgaged property has equity, there are options for the borrower which can be initiated by the borrower on their own accord. For instance, when a borrower has equity they can sell the property to pay of the lien. Additionally, to some extent, with equity comes the possibility to refinance. More equity is better than less and affects qualification.
If the property had negative equity, the borrower can not direct a resolution on their own, as the Mortgagee would not be paid in full. So, dispositions are controlled by the Mortgagee. A short can't take place unless a Mortgagee approves taking less for a lien.
In addition to disposition, the mentality of a borrower is different. When a borrower believes they have equity, they will be more apt to preserve and protect said equity. When negative equity is present they are less likely. To some extent, the greater the negative equity the higher the default risk. The borrower is in a 'first loss equity position', that is the borrower earns equity through principal paydown and through appreciation, when present. When value drops the first person to hit zero is the borrower. BTW, once the borrower hits zero, the mortgagee begins to erode too.
If the above statement were true, then 2007 crash would not have been had the impact it did. We saw the public reaction. Strategic default. Walk away.
So "NO" you don't treat underwater mortgages the same as mortgages with equity. They are not the same.
- Specialist · Westlake Village, CA · Member since 2010 · 1k+ posts · 781 votes13y
Perhaps I wasn't clear in my answer and should expand my explanation. I acquire underwater mortgages all the time, however, it is underwater to the homeowner & the lender (property is worth less than the loan balance). As the note investor the price I pay is at a significant discount so that I now have the required equity protection. The loan isn't underwater to me or my investors.
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
From a performance perspective, it is about the performance. That is all you as a Mortgagee are entitled to. The principal repayment and interest gain. A borrower who performs is living up to the obligations in the note. If the borrower handles their obligation, there is no act for the Mortgagee to seek remedy to. A mortgagee can't just decide to foreclose on a current performing note.
It is important to put the word current into the sentence as current, delinquency and default matter. Default triggers the Mortgagee's capabilities to act on the remedies provided in the note and security instrument. Current and delinquent do not. If a borrower is 30 days late for the entire life of the loan, there is not much beside send demand notice to the borrower that a mortgagee can do.
When an underwater mortgage has performance it can be interrupted that the borrower has some level of intent to stay in the property. Or they simply would stop paying. That is not to say that a non-performing mortgage means the borrower does not have intent to stay. Borrower motives for their actions are not an exact science. How long a borrower will maintain a negative equity loan is a different discussion.
From a financial analysis perspective having equity or not and having performance or not changes the financials of the loan for the investor. When a loan is an NPN that needs to go through a foreclosure disposition, the recovery of the invested capital comes by way of foreclosure auction or through REO sale. There is a whole lot of zeros and costs in between the start and finish there. Thus the discount is deeper. When the loan has performance, return will come through the payment stream.
If there was no difference, a NPN would be worth the same about of money that a Performing Note is and a Sub or Re Performing note would also be worth the same. They are not all worth the same.
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
Originally posted by Ellis San Jose:
@Dion DePaoli
Perhaps I wasn't clear in my answer and should expand my explanation. I acquire underwater mortgages all the time, however, it is underwater to the homeowner & the lender (property is worth less than the loan balance). As the note investor the price I pay is at a significant discount so that I now have the required equity protection. The loan isn't underwater to me or my investors.
Ellis, the loan is underwater when the principal balance of the loan exceeds the value of the real property used to secure it. That definition does not change.
Discounting your capital basis into the asset is your investment not the loan. They are not the same thing and are even less of the same thing when the investor and the borrower's principal balance relationship is distorted by the discount. - Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
I listened to Dave Van Horn of PPR note co. and read a bunch of his articles.
What I took out of it is that most yield is in the secondary NPN market where there is also more risk.
You can buy first position at a slight discount but not that much. Risk is spread among many loans. Some lose, some break even, and some make you money. To get the notes performing again takes a ton of effort by the note holder. The notes do not seem very liquid for me meaning the cash could be trapped for a very long time if I want to move to another investment. I could try to sell the note but I do not know how long that takes.
For me right now I am not in the investing phase for notes. Still looking at it but it looks intensive to get the return and my business keeps me really busy as it is.
With anything you have to ask yourself what the return will be for the time invested and how much structure will you have to put in place (people and systems) to manage the return??
- Specialist · Westlake Village, CA · Member since 2010 · 1k+ posts · 781 votes13y
Dion,
When a loan is underwater & assuming it is non-performing, obviously the value is less than a performing loan and should be discounted accordingly.
When the loan can be acquired at a deep enough discount, and by thinking out of the box, which I really enjoy, there are significant opportunities and exit strategies, that create opportunities for a "win-win" with the borrower & investor.
I respectfully disagree with you on a few points. First, that return is limited to performance of payments. That is how the banks got in trouble, they think like banks, not like investors. They were in a position that if they foreclosed they would lose a ton of money. Yes, you have to follow legal procedure to enforce your rights as a lender.
Further, I disagree that the definition of "underwater" never changes. If I buy a loan that is underwater. I have the power to change it with a wave of my hand. I can reduce the outstanding balance so that the loan balance is no longer underwater. (Hmmm... is this a bargaining chip for negotiation)
This is an example of just one of the multiple possibilities. Imagine this scenario where you are the homeowner. For the last 2 years, you have been dealing with the impersonal collection machine of the loan servicing department for a Fortune 500 bank. Different people calling each time, sending nasty letters in pink. You are jaded by them, ignore them, & pitch them straight into the trash can. But one day, instead of the typical collection call or nasty letter, you receive a box of cookies with a note attached, saying that we would like to lower your payments or lower your loan balance so you can stay in your home. Imagine the surprise when an actual human contacts you and is courteous, respectful, & is also authorized to cut your monthly payments in half, as long as for the next 12 months you pay on time. And it isn't a 50 page application in triplicate with a drawn out approval process.
Now instead of the $2,000 a month mortgage payment which would strangle you, you now have a manageable $1,000/month payment. Your loan balance used to be $335k but your house is only worth $250k, but thats ok, we offer to adjust you loan balance down every year so that you can be in an equity position in 2-3 years plus you keep your dignity & stay in your home.
Now it's just all about the math and quantifying possible outcomes. The matrix of best case through worst case. What is my return if they pay on time? If they pay slow? If they don't pay at all, trash the house & I have to enforce my rights as a lender and foreclose on the property? The answer is.... it depends on what you pay for the note & the expenses associated for collection & repossession. If I am happy with the return regardless of each of those possible scenarios, that is note nirvana for me.
- Investor · Chicago, IL · Member since 2013 · 2k+ posts · 1k+ votes13y
Smart man! I like your approach.
Is there a typical discount or a formula for buying non performing notes? Is there an equivalent of the 70% rule (for rehabbing) for buying non performing notes?
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
So Ellis how many notes do you currently hold and what percentage have you gotten performing and have stayed performing versus foreclosing on or taking a loss??
Dave Horn talks about "emotional equity" for a borrower. Do you find that to be the case in many instances on the notes you have dealt with??
What about forgiven debt on a note? Will the IRS hit the borrower with an unexpected nasty tax owed for you the lender writing the note down??
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
For clarity, I did not say return is limited to performance per se. I drew contrast to the two sides of the spectrum where on the left side is a non-performing loan. The recovery of capital from those assets is through REO sale or Auction. On the right side is a performing current loan. The recovery of capital is through the payment stream. And thus, to finish the picture is a little mix of both in the middle. As a loan moves to the left, the discount gets deeper. As the loan moves to the right, the discount becomes smaller. Where performing current loans can trade for par and premium pricing.
I do not understand what point you were trying to make about banks recovery of capital through payments. When a loan is funded, it is funded to 100%. That is some bank's (investor) capital. The point of the loan is to be paid back with interest. The interest is their gain. The only way to have a portion of the borrower's principal be a part of the gain, is through a discount. What is the 'other way' they can look at this or treat this?
Loans with equity are not giant losses for banks all the time. Which was sort of the question the OP asked that I said there is a definite difference between loans with and without equity. The more equity in the property the less the risk of loss. A loan with a 200% LTV generically stands to be a 110% plus loss. A loan with a 20% LTV stands to be closer to a 0% loss. This is the function of a down payment, amongst some other concepts, but it limits the risk of loss in the case of default.
If you purchase a loan that is underwater. The loan is underwater. If you modify said note, you changed it. The definition of underwater didn't change. The note is no longer underwater. However, my point which you are referring to pointed out that the invested capital basis and the note are not on equal footing all the time. In fact, they are only on equal footing when par is paid for the UPB. In any discount or premium price, the investor and the borrower have two different principal numbers. In any of those ideas, there are still two different components which is the borrower's principal balance and the invested capital. The idea that the loan becomes 'not' underwater due to your discount is not true. The loan is its own balance. Just because you purchased the loan for 20% of FMV, doesn't change the loan is 200% LTV. That is, until you change the 200% to 99%.
None of this was speaking to the potential disposition of forbearance or modification. Or any other disposition, which I don't know what 'out of the box' ideas are not widely known and practiced. There is nothing new in the industry and there is no magic in any of this. Folks have new ideas of how to work dispositions, but that is just new to them, not the industry.
Perhaps this stems from a misunderstand of idea of principal recovery. This traces back to the loan is funded to 100%. That is somebody's capital. Anytime less than 100% is paid back, somebody takes a loss. When a bank sells the loan at a discount, there is a loss. Technically, when the bank forecloses on the loan, there is a loss as the asset turns to real property. The real property sale is a gain. Whether that gain is a full or partial recovery of the capital will depend on the equity in the real property.
The OP's comment was, "So the fact the mortgage is underwater is not a underlining factor, got it, and it is more about the collateral." which is not correct. Loans with equity are different than with loans with no equity. Loans that are underwater have a higher chance of less than 100% principal recovery and loans with equity stand a higher chance of 100% principal recovery.
The OP is not the first and likely not the last to improperly jump to that conclusion. In other threads, you can see where the poster had misunderstandings of having a large gain on the 20% LTV loan, due to selling off the real property. The chances of getting the title to the collateral in that LTV is not high, so you only stand to gain from the aggregate of the principal balance, advances and fees.
- Barstow, CA · Member since 2013 · 51 posts · 7 votes13y
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
Any principal forgiveness above $600 is an income event for the borrower. This is money the borrower received that they did not payback. So the IRS says it is income.
The Mortgage Forgiveness Debt Relief Act of 2007 set the amount of relief for Borrower's who take principal writedowns on their primary residence which is up to $2.0 Million if joint filing and $1.0 Million if separate filing.
Currently, the act will last until January 2014.
There are some caveats to the rule which most CPA's can help with. - Specialist · Westlake Village, CA · Member since 2010 · 1k+ posts · 781 votes13y
How many notes do I have? Not as many as Dave & PPR.
Debt forgiveness is only a factor if I report a loss on the note & send the borrower a 1099, which there shouldn't be a loss if I am this doing it right.
Percentage of collection is really not as critical a measurement in the model I use vs. Dave Van Horn's. Dave knows that may never collect on a few notes but also knows that he will hit some major home runs with others to balance the portfolio and he may have only paid 2 or 3 cents on the dollar for them.
Because my preferred strategy is to invest in notes with substantial protective equity, you should collect 100% of the time. The unknown X factor is over what period of time, & how much how much over what you paid will you recover.
Dave Van Horn's PPR model is slightly different than my preferred strategy. Dave is willing to buy notes with less equity because he will buy larger pools in a portfolio approach & he has built a robust trade desk & collection machine. I take a much more individual approach where I rely on equity protection on every note.
Emotional equity is an important factor for his model & yes I have seen it work first hand, I just prefer to have monetary equity.
@Wendell De Guzman, there is no typical discount, it varies depending on several factors. Position of Lien, perceived collateral value, market conditions for liquidation, risk & sellers needs objectives.
@Dion DePaoli I think you are right that there may be a disconnect of understanding of terms we are using. Forgive me if I misquoted or interpreted your statements incorrectly.
My statement that, "it's all about the collateral" is a bit oversimplified & I can see how it can be misunderstood, so thank you for giving me the opportunity to clarify.
I wrote "Look at the as-is net liquidation value of the property first minus any superior liens (property taxes etc.) and liquidation costs etc."
"I buy underwater mortgages all the time but at the appropriate discount."
What I should have said was "At what discount would I have to purchase this note where I am happy if they pay and happy if they don't pay?"
Much like a true Hard Money Lender who doesn't care about credit, if his LTV is in a range he is comfortable.
Here are some oversimplified examples of the questions that matter to me:
If I buy a $100,000 note & the property has a net liquidation value of $80,000 after foreclosure, and I buy the note for $50,000 I would have a potential profit of $30,000, am I ok with that? What if it took 2 years to get it?
If the borrower re-performs and pays me $800/month for the life of the loan, am I ok with that?
If the the borrower pays for a 7 years & then refinances or sells where the net value of the property is up to $100,000 & I have received scheduled payments plus a $100,000 payoff, am I ok with that?
When I mention the "investor", I am referring to my investors and I as the defaulted note buyers, not the banks investors who blew it and made a bad loan. I am not concerned with how much the originating lender or their investors are losing or recovering, or their invested capital basis. I just want to do a trade that works, my cash for their note at a price that makes sense. As soon as I buy that note, the original lender & all of his costs , losses & expenses are not my concern. They are out of the picture. The only numbers that matter from that point forward are:
1) How much of my money goes out to acquire & fix the problem
2) How much money comes back for my return.
Oh yes, as far as out of the box, I thought sending cookies was kinda clever.
.
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
Originally posted by Ellis San Jose:
Debt forgiveness is only a factor if I report a loss on the note & send the borrower a 1099, which there shouldn't be a loss if I am this doing it right..
Ellis, I think you are misinterpreting/misreading Joel's question. Debt forgiveness for the borrower and your or your investor's investment gain or loss are not the same nor related. As an investment, you would report gains or loss to your investor. If the investment was a loss, there is no sending a borrower a 1099. The borrower had nothing to do with that.
If you forgive principal on the borrower's loan, that is an income event for the borrower and it would need to be reported to the IRS.
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