Why Investing in 2nd Mortgages Can Be Risky

Let’s face it; investing in junior liens can be risky. Even the market place trades 2^nd mortgages and other junior liens at some pretty steep discounts, especially when they’re delinquent. But why can they be so risky? Let’s take a look at the three biggest factors:

1.) Lien Position

First and foremost is lien position. Most of us know that when it comes to debt on a household, taxes come first, then first mortgages, and THEN junior liens (except in Florida where HOA’s are ahead of taxes). So you’re probably wondering how anyone could invest in delinquent 2nd mortgages if a senior lien could just foreclose and wipe you right out.

But is that always what really happens? Lien position isn’t as much of a risk as you think because in most states you have reinstatement rights where you can bring the senior lien current and pay it off to protect your investment as the junior lien holder. Even in states where you don’t have reinstatement rights, the senior lien will most likely allow you to bring their lien current. So why would they want to let you, the investor, reinstate their first mortgage? The real question is, why not? If they could accept payments on the first lien and now have a current loan on their books, why would they rather have to go through the time and expense of a foreclosure? The fact is, they wouldn’t, it is much easier to just let someone else bring their lien current. Not to mention, if you bring their lien current they have less delinquent loans on their books, giving them the ability to borrow out more money from the Federal Reserve so they can do what they do best, lend out MORE money!

2.) Notes in Bankruptcy

I know what you’re thinking, “I thought this article was about how risky it is to invest in 2^nd mortgages!” Well, not to burst your proverbial bubble, but this article is really quite the contrary. Okay, sure, I covered how lien position isn’t as risky but surely there are other risks as well, right? Like any investment, yes but I’m here to debunk at least what I feel is commonly ill perceived as risk. And the second most common “risk” I hear about is Bankruptcy. The biggest threat in bankruptcy affecting your lien is being wiped out; this is what is called a Cram Down. A cram down is a court ordered reduction of the secured balance due on a home mortgage loan, granted to a homeowner who has filed for personal bankruptcy. There are two types of bankruptcy that impact residential mortgages, Chapter 7 and Chapter 13. Sure, you do run the risk of being wiped, but often times it’s not always that cut and dry.

In Chapter 7 bankruptcy, when the process is complete, the lien stays but the note is gone. This makes the borrower no longer financially responsible for the debt, BUT you the investor can still pursue the property through the mortgage. So now it is not the borrower’s debt, it is the house’s debt BUT if the borrower wants to stay in the house then they will have to pay off the debt. Once you know this, you can then go back and start the foreclosure process; and if the borrower wants to stay in the property you’re one step closer to a workout.

In Chapter13 bankruptcy, a cram down makes the note unsecured after the borrower completes their bankruptcy plan. So the debt is unsecured, but the borrower still has to pay the unsecured debt at pennies on the dollar (this exact amount is determined by the bankruptcy trustee). If they complete the plan, they’re done. Just keep in mind that only 10 % to 25% complete the bankruptcy process, and if they don’t complete it, it’s treated like the bankruptcy never happened. Any note can go through bankruptcy, but it’s usually the Delinquent 150 class of notes (notes where the senior lien is 150+ days late) that are the ones that get crammed down, and they’re one of the cheapest class of notes out there.

3.) Upside Down Notes (or Notes with No Equity)

Another risk I often hear is that if property value falls and there is no equity to back the lien position, there is nothing to be done. Or if a junior lien that is for sale doesn’t have enough equity to back the full payoff, there is no way out. The types of notes that fall into either of these situations are also known as the Upside down liens. So to give you an example: if I have a $50K loan and there’s only $10K in equity, I can’t foreclose and liquidate the property for the full $50K, right? But that’s not always the end result. It usually comes down to one of two scenarios. If the borrower is current on the senior lien, then it’s not as risky because the borrower is usually telling you two things: that they want to stay in their home and that they have a source of income (or else they wouldn’t be paying the senior lien).

Now if they aren’t current on the senior lien, there is more risk but there are exit strategies for this, such as a short sale. In this case, the borrower could also be doing a loan modification on their first mortgage and this is showing up as delinquent, so it’s reporting a false negative to credit. The latter scenario happens more often then you would think, and really provide a great opportunity for a workout. Keep in mind, that these types of assets that are upside down are the absolute cheapest type of junior lien. It’s like my partner and VP of Acquisitions says, “There’s no such thing as a bad loan, just a bad price on a loan.”

With that in mind, I hope these strategies help to clarify why 2^nd mortgages don’t always have to be so risky after all. I look at buying notes liked I used to look at fixing a problem as a contractor. Back then; I always had my tool belt. So no matter what the damage, I could usually just reach into my tool belt and find the proper tool to fix it. I treat 2^nd mortgages the same way, so instead of avoiding buying something that’s in Bankruptcy or that’s upside down, I would much rather reach into my tool belt and figure out which strategy I could use to make it work.

Photo: Wiros

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