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Life Cycle of a Note

Life Cycle of a Note

Don’t worry if you don’t yet have a complete understanding of all the words in the FIXnotes Dictionary, this next lesson will teach you the basics on real estate debt and where private investors fit into the industry.

Every note starts with a borrower. When purchasing real estate, many people need to borrow money from the bank to afford to buy a home. The actual document the borrower signs to promise they will repay the loan is referred to as the Note and creates a stream of income for the bank.

Once the loan is originated, it can only go in one of two directions: it can remain a performing note (when monthly payments are made consistently, providing cash-flow to the bank) or become a non-performing note (a default, when the borrower fails to make their monthly mortgage payments).

When a borrower signs the Note to buy their home, they also sign a mortgage. The mortgage is the bank’s security that the loan will be repaid according to the terms of the Note. The mortgage is recorded (along with the borrower’s deed to the home) in the local county’s public records to tell the world that until this Note is repaid, the Bank has the right to take this specific property through the foreclosure process.

Tip

A debt that is secured by real estate is called a “lien”

PERFORMING LOANS

The typical American homeowner pays off their mortgage around 5-7 years after purchase. This is either because they sell the property and payoff the loan with the money they earned from the sale or because they refinanced the loan (borrow a new loan to payoff the old one).

Performing loans are often sold between financial institutions, in fact if you have signed a mortgage of your own, you may remember receiving a transfer letter shortly after you bought your home. However, the focus of this course is on loans that go through the next process – from performing to non-performing (and often back to a re-performing status).

NON-PERFORMING LOANS

Very rarely does a borrower take money from the bank without the intention of paying it back. The homeowner knows the consequence of a default and they don’t want to lose their property! However, often by no fault of their own, an unexpected event disrupts the borrower’s life – such as a death, divorce, loss of income, a medical emergency, or any combination of these events.

After 90 days of non-payment, the bank considers a loan non-performing. At this point, the loss mitigation department needs to make a critical decision. The bank can:

  • modify the loan to make the terms more affordable to the borrower
  • accept a short sale (sell the property for less than the loan balance)
  • accept a discounted payoff (accept less than the loan balance)
  • accept a deed in lieu (the borrower willing signs over the property to the bank)
  • foreclose (repossess the house and resell)
  • sell the note and mortgage to a third party

What’s interesting to know about non-performing loans on bank balance sheets is the affect these “bad debts” have on their ability to conduct normal business. The government requires that every FDIC insured bank holds a certain amount of cash reserves in order to continue making loans and accepting deposits. Non-performing loans count against these cash reserves.

To make matters worse for the bank, they are not built to handle non-performing loan resolutions at scale. If you’ve ever attempted to communicate with customer service at a bank or other large corporation, you can imagine the difficulty these massive companies have of crafting individualized repayment solutions for struggling borrowers. Taking back the property becomes even more cumbersome; now these banks are in the physical real estate business. They want to collect monthly payments without managing the actual property!

Instead, the bank uses an accounting strategy called a charge-off to remove the non-performing loans from their balance sheet. A charge-off is the bank’s way of saying “we don’t have the time or resources to resolve this loan”. Unfortunately for the borrower, the loan is still valid and until it is satisfied, their credit score suffers and they won’t be able to sell their property.

NOTE BUYER TO THE RESCUE

It is at this point in our story where we introduce the hero of the secondary mortgage market: the note buyer. A sophisticated, empathetic investor that can provide the bank with liquidity and the borrower with a resolution. After charge-off, the bank moves the non-performing loan to a trade desk to be sold for a deep discount to the amount owed.

The sale of loans at the institutional level typically happens in bulk, the bank liquidates hundreds or thousands of mortgage notes to large investment firms and specialty loan servicers. These larger buyers may work out some of the loans (make re-performing) and re-sell to other investors as cash-flowing investments or they might flip the non-performing loans to local investors better equipped to handle non-performing loans in their “backyard”.

Once a non-performing loan is in the hands of a private note investor, it’s a matter of locating the borrower and negotiating a resolution to the delinquent loan. This will be discussed in-depth in the Asset Management section of this guide. For now, we’ll just touch on the life cycle

WORKING OUT A DEAL

As you now know, the reason the bank decided to sell the loan was because they did not have the time or resources to come to a resolution with the borrower. Sometimes, that’s simply because they couldn’t make contact. A savvy note investor has the tools & time to find their borrower to share the good news: their loan is now owned by an investor who can think outside of the box and help them come to a win-win resolution.

After making contact and showing the borrower their recorded Assignment of Mortgage (the note investor’s evidence of ownership, on record in the local county’s public records), there are three questions that give the investor almost everything they need to know about the borrower to move forward:

What happened?
Where are you now?
What do you want to do?

The answers to these three questions will set the stage for the next step, the investor’s exit strategy. What is the best way to help this borrower pay-off their debt? There are only two ways that a mortgage note is settled, through the property or through the borrower

EXIT THROUGH THE PROPERTY

  • accept a short sale (receive less than the balance due at property sale)
  • accept a deed in lieu (the borrower signs over the property to be rented or resold)
  • foreclose (the investor repossesses the house to rent or resell)

If the answer to “what do you want to do?” is to sell the property and move out – that is how the investor can help the borrower. If the property is vacant and the investor can’t find the borrower, exiting through the property is their only option. If the borrower doesn’t want to help themselves, sometimes the only option is to exit through the property.

EXIT THROUGH THE BORROWER

  • modify the loan to make the terms more affordable to the borrower
  • accept a discounted payoff (accept less than the loan balance)

When the borrower decides they want to keep their home, it’s in the investor’s best interest to find a way to make it affordable to them to stay. Because of the substantial discount that non-performing loans are bought and sold at, private mortgage investors have much more flexibility to find a workable solution while still running a profitable business. A discounted payoff at 50% makes a huge difference to the borrower and when the investor purchased the Note for 25% of the balance due, they’ve doubled their initial investment!

If the borrower doesn’t have a lump sum to payoff their loan a discount, the investor should act as their personal financial advisor to find out how much the borrower can afford to pay on a monthly basis. Sometimes that means looking over their bank statements and coaching a borrower on their budget (how many times per month do they really need to eat out if they can’t afford their mortgage). At the end of the day, resolving non-performing mortgage notes is about the borrower. Your job as note investor is to help them come to a sustainable repayment plan that sets them back on track. Succeed where the bank failed!

Now that you know how a note is created, how a mortgage secures that promise to pay to a property and how/why the note and mortgage are sold and then resolved by private investors, it’s time to move on to the next section – History of the Opportunity.

If you’re confused or need any clarification, feel free to leave a reply below with your question or comment. We will do our best to review your comment and reply!

 

4 COMMENTS
  1. Silvia Century says:

    Thank you Robert! That was very informative. I learned a TON about mortgage notes.

  2. Rick Sabatini says:

    Rob, great work here! Thanks for shedding light on such a confusing process!

  3. Teresa says:

    Thank you SO very much Robert! So much valuable, easy to understand information, I really appreciate and value the education.

  4. Roy says:

    Great job explaining what others confuse in their well-meaning efforts. Looking forward to next steps.

    Thank you!

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