Is a heavy discount on a NPN usually a red flag? Why would it be so cheap?

[Jay Chen]

I have learned a lot from this forum and think I am finally close to ready to buy my first note, but have some remaining concerns to address. Thanks for providing a great resource, hope you guys don't mind a few questions.

On FCI Exchange I've seen a number of notes that are very low %UPB, like 10% or 5% or sometimes even less.

Now %UPB doesn't matter that much, it's the difference between the cost of the note and the value of the underlying security that matters. But even with some of these, I'm seeing deals that almost seem too good to be true. For example, a 1st on a $40k property selling for $5k.

What's happening here? I can think of these reasons, are there any more I should watch out for?

The borrower has filed for BK

My estimate of the property value is inaccurate, a proper BPO or appraisal would value the property far less

Unpaid property taxes/HOA fees

Borrower is very difficult to work with

Property located in state with very lender-unfriendly foreclosure laws

Potential enforceability issues with the note 

Defective assignments

Documents lack required formalities like signatures of all borrowers; notarization

Terms that constitute predatory lending? (not sure how much this matters)

The note is in 2nd position and would be wiped out by the 1st at auction. Can't count on auction proceeds as an exit option for these.

Exit costs are too high

Cost to hire an attorney or trustee to foreclose

Costs to hire an attorney to draft a loan mod agreement, satisfaction of mortgage, etc.

I'm also hoping you guys could provide some insight on the seller's motivation.

Why would somebody choose to sell a note on FCI? I can understand why banks want to sell notes. I'm not at the level where I can buy direct from the bank; I have to go to brokers, hedge funds, people on FCI. But why would the middleman willingly leave money on the table by selling a profitable NPN?

I assume they keep the best ones for themselves, but just because they're selling the note doesn't mean it's not profitable at their asking price. They understand that a smart buyer will do their best not to overpay and will be looking at the same factors to put a price on the note. In other words, unless they're hoping to sell to an unsophisticated buyer (possible), the seller has no choice but to leave some money on the table. Does it mostly come down to the fact that the rate of return over time that they'd get from working the note is lower than the return they would get by putting that money into buying another big pool?

Also, is it reasonable to assume that notes on FCI will have been "worked" to some degree, and that exiting through the borrower is less likely? I assume that if the note is selling for $5k, then that means the borrower can't or isn't willing to hand the seller $6k to satisfy the note? 

Thanks for any insight you guys can provide.

[Dion DePaoli]

@Jay Chen 

The price expectation of an asset, priced well, will reflect the time and expenses it will take to enforce the security instrument and the potential recovery of proceeds.  While your list of questions is extensive, I think many folks struggle with many of your same questions, so with an adequate amount of coffee this morning I will see if I can buzz through them for a better understanding:

The borrower has filed for BK - A BK is not the cost barrier that most folks think it is.  A BK 13 would mean the mortgagee should stand to be paid.  Time would be a concerning metric.  A BK 7 would likely lead to relief in short order continuing the FCL.

My estimate of the property value is inaccurate, a proper BPO or appraisal would value the property far less - This is always possible. If you are not good at property evaluation, you should really work on developing that skill. It is essential for any REI.

Unpaid property taxes/HOA fees - Yes, any lien which can infringe on the Mortgagee's lien that would require payment opposed to being wiped in a foreclosure will cause a deeper discount since it increases the expenses.

Borrower is very difficult to work with - It is safe to say all NPN borrowers are difficult to work with.

Property located in state with very lender-unfriendly foreclosure laws - This would translate into time.  Time can cause the discount to increase.  That said, an asset priced right for it's time produces the same return as quick time line asset.  This has more to do with the patience of the capital invested than anything else.  20% in NY is the same as 20% in TX.  A 20% return is a 20% return.

Potential enforceability issues with the note - Probably not this.  This is more layman misplaced fear spurred from misunderstandings.  

Defective assignments - Probably not this.  A borrower would have to contest standing in most cases and possession of the note itself is winning many of these arguments.

Documents lack required formalities like signatures of all borrowers; notarization - Probably not this.  While not unheard of, not as common as folks want to think.

Terms that constitute predatory lending? (not sure how much this matters) - This could be a concern, but you should be able to look at some of the top line note data like interest rate and see if it is usurious.  Not sure a lender who does such things would be so nice as to price the asset cheaply.

The note is in 2nd position and would be wiped out by the 1st at auction. Can't count on auction proceeds as an exit option for these. - This would be a valid reason for a larger discount.  Detecting the note's position is fairly straight forward.

Exit costs are too high - Exit costs are high and time table is long.  That will always drive the discount up and the price down.  

Cost to hire an attorney or trustee to foreclose - Factored in the above idea.

Costs to hire an attorney to draft a loan mod agreement, satisfaction of mortgage, etc. - No.  Getting a modification on a loan would mean the borrower is willing to reinstate, which means the borrower is willing to start paying.  That would increase the value of the note and the payments would offset the cost of preparing a mod (which really should not be that much money).  You are not entitled to the property only the principal and interest.

Why would somebody choose to sell a note on FCI? I can understand why banks want to sell notes. I'm not at the level where I can buy direct from the bank; I have to go to brokers, hedge funds, people on FCI. But why would the middleman willingly leave money on the table by selling a profitable NPN? - Well simply because they want to sell their note.  That is really all there is too it.  This notion that a "bank" is some type of sophisticated Seller is misplaced.  Local and regional banks simply do not carry that many bad loans, they are not big enough and didn't originate like the Commercial (Conduit) Lenders that went belly up.  The big commercial banks do not deal in such small amounts of trades as to make it possible for a street level guy to buy a loan and lots of investment funds can not get in on the party either, despite common folklore.  It has nothing to do with sophistication.  Idiots can work anywhere.  Hopefully you are not working with "middlemen" who are pushing the price up on an asset.  No matter where you find the asset a Seller is a Seller.

I assume they keep the best ones for themselves, but just because they're selling the note doesn't mean it's not profitable at their asking price. They understand that a smart buyer will do their best not to overpay and will be looking at the same factors to put a price on the note. In other words, unless they're hoping to sell to an unsophisticated buyer (possible), the seller has no choice but to leave some money on the table. Does it mostly come down to the fact that the rate of return over time that they'd get from working the note is lower than the return they would get by putting that money into buying another big pool? - This is both straight forward and complicated. Lower level assets are pretty risky. It is easy to slip into major expenses that remove any recovery proceeds. Larger capital firms would rather be secured by better (higher valued) collateral. Some companies have tried to make a business out of buying these lower value assets and reselling them to street level investors. DO NOT THINK A SELLER CARES ABOUT YOUR PROFIT. That is your problem not theirs. Working the street level investor angle is not all that easy. Most of the time the investors are new and inexperienced and frankly price things way, way, way under value. The fear of the unknown mixed with aggressive return expectations. It is safe to assume that Seller's will not go out of their way to hand you and easy return. Offering loans for sale in an auction type setting helps them flush out good pricing. There are Sellers who are not all that sophisticated, folks who buy NPN's with the intent to resell hoping they can create a profit. Those folks prey more on the lack of skills of their downstream trade partners than not. I wouldn't call them note investors. I would call them hot potato jugglers. Would you buy a $5k house?

Also, is it reasonable to assume that notes on FCI will have been "worked" to some degree, and that exiting through the borrower is less likely? I assume that if the note is selling for $5k, then that means the borrower can't or isn't willing to hand the seller $6k to satisfy the note? - It is reasonable to assume that all notes have been worked.  Period.  You can never know when life changes for a borrower.  Sometimes a little extra effort on the investors behalf can cause contact and then a solution.   I like to call it "Ostrich Syndrome".  When good people fall onto hard times, they stick their head in the sand.  In that sense, some "typical" routines deployed by Mortgage Servicers like mail campaigns and auto-dialer phone calls are not enough to get a borrower to pick their head up.  In addition, there are certain barriers on institutional investors which make some workout solutions difficult to do.

Lastly, a comment toward the amount of money you have set aside. Remember, that when you go purchase a NPN you will have the cost of buying the NPN and you will also have the cost of enforcing the security instrument and holding on to the asset. When collateral values (real property) drop below $50k there is strong downward pressure on price since it becomes harder for the collateral to "fit" all of the costs need to properly enforce the security instrument. (ex: $5k in taxes is 10% of value) This coupled with time will commonly push lower level NPN's (less than $50k in RE Value) down to 20% of RE Value or lower depending on the time and additional expenses like paying for taxes and liens.