Supply and Demand 101
When I was in college, I took an economics course. While I only got a “C” in the class, one thing I did takeaway was the concept of “Supply and Demand”. In my 25 years of investing in distressed second mortgages, I’ve seen the concept in action many, many times.
Recently, I had my students look at a list of loans from a seller and place bids on the loans they were interested in. I told them to be aggressive and based on today’s market (and the quality of the loans), they should be bidding between $.25 to $.50 on the dollar for these non-performing loans.
A week after I submitted their bids, I got several emails and calls from my students frustrated that they weren’t awarded any of the loans. They told me they each bid between $.40 to $.50 on the dollar. When I contacted the seller to inquire, he informed me that the winning bids were between $.60 and $.80 on the dollar!
How could this be? Paying $.60 to $.80 for a non-performing loan? It’s preposterous!! How could anyone truly make money buying a non-performing note at those prices.
Let's break it down and look at it this way. I pay $.70 on the dollar for a second with a UPB of $20,000. My cost is $14,000. If the borrower has a 20-year mortgage at 6%, he's paying about $150 per month. Now let's assume that you're able to get the borrower to start making those payments. Based on what I paid for the loan, it's going to take 93 months to get my money back. That's roughly 7 ½ years! A lot can happen in that amount of time.
Let's look at it another way. Say we get the borrower paying and they've made two years' worth of payments and you now have a "seasoned", re-performing loan. You put it on the market to see how much you can get for this loan. Remember, after two years of payments, their UPB will have decreased about $500.
How much higher do you think you’ll be able to get for the loan? You paid $.70 on the dollar. Even if you got $.85 on the dollar, that’s only about $2,500 in profit. Now, add that amount to the two years of income at $150 per month. Your total income for this loan is about $6,000 compared to your cost of $14,000.
Am I missing something here? Although I didn’t get an A in my economics class, I think we covered profits and returns on investments.
Even if you’re able to get some of the past due balance, you still have a long way to go to break even.
My only explanation I could give my students is that the buyers of those loans were probably inexperienced and didn’t realize the full implications of their bids.
However, because of the bid offers this broker was getting, I decided to have him try to sell 13 of my non-performing loans. The results were pretty good. Of decent loans I was selling, the average price was about $.65 on the dollar. For my not-so-good loans, the average bids were about $.30.
I offered these loans to eight buyers, gave them links to the collateral folders and asked them to give me final bids within a week. Most of the buyers said they needed at least two weeks, which I found a bit long considering they weren’t ordering title. However, I granted them the two weeks.
During the two-week due diligence periods, I was asked to provide pay history and servicing notes. As far as pay history, in many cases, there is none. These are “non-performing” notes where the borrower hasn’t paid anywhere from one to 15 years.
Regarding the servicing notes, most sellers and servicers do not provide this. It’s too risky for the seller. Let’s say an account executive put something in writing in the notes that he/she shouldn’t have. It’s opening up the seller to a whole lot of liability. There may also be proprietary information in the notes that’s confidential to the seller. However, some sellers do offer call logs which can be helpful as far as procuring telephone numbers. A good way to look at it is that you are getting a clean slate when you’re buying this note. An opportunity to start over with your own style with the borrower.
Many times, I’ve worked on a loan that’s been sold three to four times before me and I’ve been able to get the borrower on the phone and to start making payments. I think to myself, “am I that much better than any of the other investors who have tried to get this borrower paying”? No, I’m just lucky.
For this pool of loans, two of the buyers emailed me saying they weren't going to buy the loans because they weren't able to confirm the status of the first mortgage. This confirms my suspicions that these buyers are new to the business. If you can't find the first mortgage in a credit report, then you need to check out the County records to follow each lender's trail. You'll be more than likely able to find all the loans that were originated, sold, transferred, and satisfied. You may not be able to get the current UPB, but you'll be able to see the origination amount. Take the worst-case scenario and use that amount in your calculations. Sometimes, you have to dig a little deeper and make assumptions. If it were that easy, everyone would be investing in distressed notes.
Out of the eight buyers and 13 loans that I started with, only four of the loans were sold. Don’t get me wrong, some of the reasons for not buying were legitimate, but some were not.
As a buyer and a seller, I see both sides of the coin. As a buyer, I want to make double-sure that the loan I’m buying is as clean and risk-free as possible. As a seller, I wish buyers understood when they’re awarded loans, I’m taking these loans off the market specifically for them. I’m telling the other buyers they were outbid and won’t be getting their loans. Now, after two weeks, I have nine loans that I’m going to put back on the market and have the other buyers who bid on those loans wonder why they weren’t sold.
In the end, we’re investing in crazy times. I can be one of those folks that says, “in my day, I remember second mortgages going for $.05 on the dollar, but that won’t help anyone”. What I will say is, “I would rather walk away from a loan than pay way too much for it and end up chasing my tail trying to just break even.”
I remember my college professor told me, “if it satisfies a need, demand comes first. If it satisfies a want, supply comes first.” Good food for thought…