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Non-Performing Note Investing: How to Prevent 2nd Mortgage Notes from Becoming Wiped

Dave Van Horn
4 min read

When my partners and I first started investing in non-performing notes, one of our biggest fears was what we call in the note industry, getting “wiped” on a note.  Keep in mind at the time we were just venturing into delinquent second mortgages, a category of notes that many find risky for just that very reason BUT also much like 1st mortgages, 2nd mortgage notes are a secured investment backed by property AND are much less expensive.  This was a time when there was a lot of equity still in the market and prices of real estate were actually increasing.

Our biggest fear was that a first mortgage on the property where we held our second lien would foreclose ahead of us and we would in essence get “wiped “.  The reason for this is because the foreclosure attorney representing the first mortgage company at the foreclosure sale is only concerned about protecting their client’s interest and would either start the bidding at what the 1st mortgage was owed or at a number they’d be happy with.

In most cases, they start with what is owed, and in a down market like we’ve just seen, the bank will take most of the properties back as an REO (Real Estate Owned), and just liquidate them.  If for some reason the bidding went beyond what was owed on the first mortgage any additional proceeds would be applied to any other secured liens (if there is any), and anything above that would go to the homeowner, (be sure to note that this is after any sheriff fees have been paid).

How Due Diligence Helps

As a newbie buyer to delinquent second liens, the one thing we did as part of our due diligence was to get clear on the status of the senior lien, and once purchased, we continue to monitor the senior lien on a monthly basis.  By knowing the status of the senior lien and the fact that they hadn’t started foreclosure yet gave us the ability to start our foreclosure on our Junior lien, ahead of the Senior lien, and this gave us the ability to control the foreclosure sale.  The reason this is so important is because our foreclosure attorneys’ bidding instructions would be for an amount acceptable to us, whether to cover all of our lien, or just a number that we were happy with.  So, if someone bought our lien at foreclosure sale, or we took the property back because there were no bidders, either way it would be “Subject To” the Senior lien.  But now, one of us would have the Sheriff’s Deed, and thus control of the property to either sell, rent, repair, etc.  Notice that the first has not been paid off, or on, at this point. (Also, keep in mind that this happens to us on LESS than 10% of our loans).   Now, if nothing is done in the near future, as far as re-instating, or paying off the first mortgage, in most cases, they would proceed to foreclose against the new owner.  But for the time being, the previous Junior lien holder, or investor is in control of the property.

But What About Equity?

To drive a point home, I have to tell you that, like everyone who is new, I had plenty of misconceptions about notes. Now, years later after working 1000’s of loans, I’m going to bring up one of the biggest taboos of all…BANKRUPTCY!

The second biggest fear towards being wiped, for a newbie investor in delinquent second liens, is if for some reason, property values plummeted and there was no longer any equity backing the second mortgage and a homeowner would just file bankruptcy and strip or “cram down” my Junior lien through the bankruptcy court (**NOTE** If there is a even $1 of equity backing your lien, than it should not allowed to be stripped)

Also remember, this is much easier said than done, for a couple reasons.  First of all, it can get expensive for the homeowner, and can become highly contested, thus requiring a full-blown, court ordered, appraisal.  And even if it is granted, the borrower must complete their bankruptcy plan and be completely discharged, otherwise, it’s as if it never happened.  Just so you know, after working with thousands of borrowers, we’ve seen the large majority of homeowners never complete their plans partly due to fluctuating restrictions that vary from state to state.  That being said, my company owns thousands of loans, over the last several years, and the number of cram downs is a very, very, low number.  You might be thinking, “Why doesn’t every homeowner try to strip an upside down lien?”  Well, when a homeowner is current on the first mortgage, they usually want to stay, and obviously they have a source of income.  They also have what’s called, ” Emotional Equity“. This was a very tough concept for me as a real estate investor to grasp and understand.

What We Learned From the Market Crash

Another interesting thing happened to us while we were relatively new to nonperforming note buyers, when the market finally did crash.  You see, up until that point we only focused on equity deals.  There had still been plenty of them available and we were petrified to death of anything without equity.  But after the crash, all of a sudden the majority of our portfolio had no equity.  At first, we didn’t know what to do! When we had previously bought 2nd mortgages that were current on the first mortgage, we would get out of, nine out of ten equity deals.  Now, we didn’t know what was going to happen, but we continued to work the loans because we didn’t have much choice since we already owned them.

You’ll never believe what happened. We continued to get seven or eight out of ten deals, regardless of ‘equity’, (< than 200% loan-to-value), when current on the senior lien.  Today, we make most of our revenue off loans without equity, and we purchased them for a fraction of what our equity deals had cost.  In fact, we sell off most of our ‘equity’ deals, since we can do so at a premium.  Besides, there’s not as much potential upside to these loans either, once the equity does come back into the marketplace.

So, the good news is, all our original fears when starting out have proven for the most part to be unfounded.  If you do the proper due diligence and you’re diversified enough, the fear of being wiped is not even worth worrying about.  And if you’re like me, after you work a lot of notes, you start to get excited about getting wiped on a loan because that means you get a tax break to offset revenue!
Photo: Orin Zebest

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.