The Life Cycle of a Note

Notes, Note Investing, Non- Performing First, Seconds  . . . this seems to be coming at us from every direction these days and for good reason.

First, the banks are holding back trillions in defaulted loans trying to figure out how to sell them as written off loans rather than foreclose and turn them into REOS.   Why?  Well because foreclosing on your customers is bad PR and it costs way more to take a property through foreclosure and ultimate sale as an REO than to just sell as bad paper.

Secondly, the ups and downs of the stock market are turning a lot of people off and they are looking for alternative places to invest their money.  They are turning more and more to real estate either as active investors or as passive investors.  They may be learning how to invest themselves or putting their funds into huge capital pools that today we call a Hedge Fund.

Where are the Hedge Funds putting their money?  Buying Bulk REO, Notes and other real estate items like tax liens.  But the notes are so flexible and so cheap.  The Hedge Funds can buy a pool and strip off the higher end loans that they want and sell the rest at a loss to someone else and still make huge profits.  These stripped off loans eventually make their way down to the little guy who can then work through the life cycle of the loan.

So what is the life cycle of a loan?

First a loan is originated.  A borrower signs the note, their promise to pay.  Next the borrower makes payments as agreed and eventually the note is released and the borrower then owns their home free and clear.  

Sounds great!  Well, at least as long as they pay as agreed, but what if they don't?

The lender can then take steps to make the loan good or sell it at a huge discount to someone who will take those steps.  In the big institutional lenders cases, usually their choice is the sell at a huge discount.

So say for example Bank of America made a $100,000 loan and the borrower stopped paying.  Bank of America made a few feeble attempts at making them pay and here it is 3 or 4 years later and BofA probably bundled this loan up with several 1000 others and sold it to a Hedge Fund for 50 to 70 cents on the dollar.

Because the Hedge Funds don't really want this low of a valued note they sell it out of their pool, and eventually it makes it to us as a small investor at 30 to 50 cents of the current value of the home.

So if I were to acquire this $100,000 loan that was made 3 or 5 years ago at the high of the market, it may be worth about $80,000 today.  I can acquire a loan that was about $100,000 when it started for about $40,000.

Great!  Now What?

Step one is to contact the home owner to see if they live there and what they want to do.  

If they live there and they want to keep their home, I am sitting in a very great position.  They probably owe about $85,000 on this note, assuming they made some payments before they stopped.  I am owed this same $85,000, but I only have $40,000 invested.

I could offer the borrower a short payoff of say $60,000, they could refinance and pay me off and I just made a quick $20,000.

I could offer to modify their loan and adjust the interest rate down and recast the loan to more payments and lower their monthly payment significantly and over then next 30 years or so earn a huge return.  Or let them make payments for a few months and sell the now performing loan at 70% of the $85,000 balance and make a great profit.

Second Step is if they don't live there is to offer the 2nd option.  Find the home owner and see if they would want to just deed us the house.  Often times they do.  Then I own and $80,000 house that I only paid $40,000.  Now I can sell it as is for a profit.  Renovate it and resell it to a landlord, a home buyer or who ever.

The Third Step comes in when either the Home Owner cannot be found or they just will not cooperate.  This is when we start foreclosure.  We may be able to use the foreclosure action to get them into gear to do one of the above steps.  Or we see it through to the end and foreclose and own the house with the $40,000 we already paid and then the legal fees of $1500 to $3000 - (at least in the states I work in).  Now it is an REO and we can dispense with it how ever we normally would.

The key to the whole life cycle at least for the Note Investor is knowing the how to do your research so you minimize the risk in the note.