To properly explain how distressed mortgage note investing has come to be, we must first go way back in time to the Middle Ages – 1,000 years ago, when the term mortgage was coined. Translated from Old French, mortgage means “death pledge”. A mortgage was created when borrowed money was secured by property as collateral. This pledge dies when the debt has been repaid or the property has been foreclosed. To this day, the general premise remains the same.
By the early 1900s in America, mortgages had variable interest rates, high down payments, and short maturities. The majority of borrowers worked with local bankers, sometimes renegotiating their loan annually. The Great Depression destabilized the market, and the government stepped in to provide confidence. The most important institutions that were created were the Home Owner’s Loan Corporation (1933), the Federal Housing Administration (1936), and the Federal National Mortgage Association (1938) later known as Fannie Mae.
After World War II, the government added more programs to stimulate the real estate market. The Veterans Administration mortgage insurance gave banks the ability to write riskier loans to give more people the opportunity to buy homes. Between 1949 and the turn of the century, down payments decreased and mortgage debt relative to total income of the average household rose from 20% to 73%. Loan-to-Value ratios rose to 95% and the maximum mortgage term was extended to 30 years.
The Government National Mortgage Association (Ginnie Mae) was established in 1968 to bring uniformity and liquidity to the mortgage market while also bringing about the invention of many complicated financial instruments. In 1970, the Federal Home Loan Mortgage Corporation, known as Freddie Mac, was formed to promote home ownership by adding liquidity to the secondary market. By 2003, governmental mortgage institutions held 43 percent of the total mortgage market. Between 2003 and 2007, federal loan programs, policies and complex financial instruments designed to encourage home ownership and stabilize the market continued to expand to the point of no return…
THE SUBPRIME MORTGAGE CRISIS
In July 2007, the investment bank Bear Stearns announced that two of its hedge funds had imploded after investing in securities that derived their value from mortgages. For the years to come, the entire economy felt the pain. Two resources for an in-depth review of the crisis – the book/movie: The Big Short or the Wikipedia: Subprime Mortgage Crisis. We won’t go into as much depth here as the purpose of this lesson is to show how today’s mortgage note investor fits into the industry at large.
The main cause of the Great Recession was the abuse of two financial instruments: the mortgage backed security (MBS) and the collateralized debt obligation (CMO). Ginnie Mae guaranteed the first mortgage pass-through security of an approved lender in 1968. In 1971, Freddie Mac created a similar instrument in the “participation certificate”. In 1981, Fannie Mae issued its first mortgage pass-through, called a mortgage-backed security. Then finally, in 1983, Freddie Mac issued the first collateralized mortgage obligation.
In theory, the MBS & CMO were excellent ideas – they packaged up thousands of mortgage notes into an asset-backed security, an investment that provided cash-flow to investors diversified across thousands of mortgage notes. In practice, the standards of the banks creating these securities slipped as easy-money poisoned the minds of an entire industry.
As a mortgage note investor in the secondary market today, mortgage backed securities and collateralized debt obligations aren’t a regular part of our vocabulary. Investors like FIXnotes purchase mortgage notes referred to as “Whole Loans”, each loan is a single note + mortgage that has never been securitized or packaged into complex instruments. Each loan is a standalone asset consisting of a borrower, a lender, a property and the documentation connecting it all.
WIN-WIN FOR EVERYONE
Buying a borrower’s note gives note investors the power to resolve tough situations at a fundamental level; the need for affordable housing. Solving these problems for people is an incredibly satisfying position to be in, and it sure pays well!
Benefit to Banks: By selling non-performing loans, banks are able to remove what regulators consider to be “toxic” assets on their books. By giving them liquidity to unload these non-performing loans, they are able to keep doing what they do best: lend money.
Benefit to Borrowers: Without creative note investors to create viable solutions for borrowers based on their needs, many more homeowners would be forced to file bankruptcy or find other, less suitable living arrangements.
Benefit to the Community: Housing is a big part of the local economy and neglected properties bring down the value of entire neighborhoods. When a homeowner is not paying their mortgage, they’re typically not paying their taxes or other obligations.
By transforming non-performing mortgages into performing assets, note investors not only help borrowers through their financial struggles but they also help improve communities.