Purchasing a Note with Term Errors

[Mike Hartzog]

First things first... Happy New Year everyone!  I hope your 2015 is off to a good start. 

I have a hypothetical scenario for you to ponder. Let's say you are looking at purchasing a performing note, but after doing that math on the note terms you realize that the payment called out in the note is a bit higher than it should be. The P&I payment the borrower has been paying since 2009 translates to a rate .05% higher than the rate called out on the note. The note term is 25 years, so there is plenty of UPB remaining.

This is clearly not a great situation for the note purchaser but lets say for sake of argument that we are getting a very nice discount on the note so we are inclined to try to make the deal work.  Let's also say that the borrower has no idea there is an error and neither does the seller but you, the purchaser, are an ethical and honest business person so if you purchase the note you want to fix the issue rather than bury them.

So the question is, what would you do in this situation?  Would you walk away?  If not, how would you try to work with both the seller and the borrower?  What potential legal liabilities do you see here?

[Dion DePaoli]

Mike,

I have seen this many times. Mostly as a result of modification but a couple in origination. There is zero reason to walk away from this and I would add I would not really "feel" bad an error is an error unless it was intended and most of the time these situations are not intended to take place. I am not inclined as a Buyer to share any discoveries such as this with a Seller unless the error would cause a greater discount that needs some explanation. I do not need a Seller to fix this as I would want to make sure it is done correctly and to my liking.  So with a correct yield calculation you make your bid and buy the asset and then deal with the error. Due diligence needs to look to the history and origin of the error to understand what steps you need to take on the account to correct the ship. Like I said no need to alert the Seller IMO, and more than likely this is not likely an error which would cause the already present discount (assumed) to greatly increase.

I would double check your assumption by looking to the current balance and where it should be in the amortization of the loan.  The payment should be resulting in prepayment. A faster reduction of principal. (advantage to note buyer with slightly more equity!) If the prepayment is not being properly applied to the account a balance correction to favor the borrower will need to take place. Any correction to a Borrower's account which is a net benefit to the borrower can take place with minimal interaction of the borrower. In other words, just make the correction and move on. It is always nice to get a pat on the back from the Borrower but sometimes stepping into the light can backfire on you.

It may be relative to understand if the error caused any incorrect applications of late fees. Depending on the note language a late fee may be a set amount or a percent of the payment. So if they have been using the payment which is in excess the late fee amount would also have excess. Not to mention any partial payments or payments held in suspense. Take steps to ensure the borrower gets credit as needed.

To speak to due diligence just a tad more. It is not overly unusual for a servicer to be handling this properly already. So I would not jump to conclusions without reviewing a payment history from the servicer. Obviously if this loan is an ARM the error would have a bit more of an impact and require a greater correction. Sometimes a servicer will aggregate the prepayment in suspense before applying a full payment. In example, if the general overage is $50 and the payment properly due is $500 then after ten payments the servicer will apply one full payment and the borrower will be ahead one period. The amount can also be applied on a per period basis as the payment is made and applied. Both methods are fine.