A question on notes

[Ross Ellington]

Hey BP! I was wondering when you buy a note what is the avg. amount you can get in on. 50 cent on the dollar kind of ratio. I thank you guys in advance for any answers or feedback. Have a wonderful night :)

[Dion DePaoli]

I thought this was a pretty good question that has not been addressed in a little while.  I also thought it would garner some more responses than this.  Kudos to Bob M.  I have some time today so let's give it a whirl.

First let us understand that there are 3 basic ways to purchase a loan: 
Premium = 100%+ of the balance
Par = the balance
Discount = less than the balance

I like to always included that so we can  understand that the greater marketplace is actually for premium and par loans.  Discounted loans are a much smaller piece of the overall fluid market somewhere in the 25% to 35% range.  A large enough number onto itself but certainly not the leader.

Next, let us take the notion of "average" used in the OP and remove it completely. First, as illustrated above the average as a mode or mean is likely not even a discounted loan if we were to group such things. The fact is the mode of loan purchases is a premium. Out of all of the loans in the universe the prevailing pricing structure is 100% PLUS of the balance. If I was a wagering-man and such things could be reasonably quantified I would guess the price is close to 103% of UPB. Viola the "average". I suspect that is not what most where thinking.

Since for the most part this forum trends with discounted loan discussions and the OP's questioning suggests a discount example of 50%, we will head that way. That said, we must keep those other loan ideas in the back of our minds as they do from time to time have relevance. At the very least, they can provide for some management of unreasonable expectations if they try and arise.

So now we are standing in the circle of discounted loans only.  Before we continue we should understand that this group, like the parent groupings, also has subsections.  So to be clear not all discounted loans are the same.  Before we look into that we should pause and give the idea of discounted loans a little more in-depth definition.  Perhaps the simplest definition we can use is "Discounted Loans are discounted because they have some form of a defect or many defects."

What is a defect?  As we would suspect a defect is any flaw, imperfection of lacking.  So how does that apply to loans?  

Well we can have defects in paperwork that might or will affect the enforceability of the obligation created in the note.  We can also have a defect in the paperwork where report taking about the collateral for the loan is misrepresented.  For instance, an inflated appraisal.  It does not stop there, we can have imperfections such as a lack of continuous payments being made.  Finally we can even have a lacking, that which should be present is not.  

Now it is important to pause there for a minute to make sure we do not include some loans in this universe.  What types of loans might those be?  Well for ease of conversation let's just call them "bad loans".  So what is a bad loan?  Well a bad loan is a loan that simply should not have been made.  I feel it is important to bring this idea out here in BP as we have some discussions (in various forums) which attempt to create an inclusion of bad loans with defective loans.  Another testing idea to discern the group would be was the defect made on purpose?

A little foreshadowing there probably has some folks nodding there heads.  Loaning money to a Borrower with a 480 credit score is not a defect.  It is bad loan.  Lending money on inflated real property values is not a defect it is a bad loan.  The list can continue but I think you get the idea.  We must set aside this group for the sake of our conversation.  Bad loans are discounted loans but not all discounted loans are bad loans.  An important idea to understand.

Often times we simplify the defects in layman's conversations to simply deal with payment performance.  This makes sense and creates easily understood ideas to some extent.  A loan which makes no payment that goes into 90 days or plus past due is consider a non-performing loan.  All other loans then get the label of performing.  We could just keep it simple with non-performing and it's popular antithesis of performing.  Most of the time in casual conversation, where we discuss this group of defective loans, this will do just nicely.  However when we voyage towards pricing discussions this over simplified idea is not sufficient.  It seems that the audience often times forgets that par and premium loans are the prevailing loans of the market.  This creates a bit of a conundrum in conversation, is a performing loan a defective loan?  If the loan carries no defect, then is there a discount?

To keep this simple and still bring out the point lets discern a grouping of performing loans which are eligible for a discount because of a defect of payment.  In other words, if we take two loans one which has made all payments as agreed and one that simply has not, we can understand there is a difference between the two.  Now is there some type of cross-over bridge which derives itself from default?  Yes, but it is not so neatly defined.  Enter the idea of seasoning as it is used in discounted loan discussions.  

Often times we hear "seasoning" as an offsetting idea to discount.  In other words, look at how Billy Borrower just made 12 payments (Yea Billy!) and because of what he did in the past you should presume the propensity for him to continue as agreed is now high again.  Inside this idea we have additional concerning notions.  How many previous payments create a propensity for his future payments to come in as agreed?  The answer there is pretty simple....it depends.  

There is no magic number there.  Other influences and factors must enter the picture.  Seasoning or "past performance" is not a sufficient barometer on its own all the time.  We have all heard the investment disclaimer "Past performance may not be indicative of future results.".  (Well, thanks for nothing Billy)

Now before the defaulted loan reader's head explodes with too much information we can circle back and point out that "default" is defined and widely accepted.  Default is a loan which is 90 days past due.  Not to be confused with the regulation of Notice of Default being 120 days past due.  Any loan in default at 90 days is still in default at 120 days (obviously) action just can not be taken any earlier.  None that changed the definition.  To carve out the defaulted loans brothers and sisters we have "current" which is a loan not past due.  Then in-between is delinquent.  

Now, all of these loan performances can still have a defect and thus warrant a discount.  Commonly we look to defaulted loans being the easiest to understand that the default itself is the defect and thus creates the discount.  Many times this is true but it is not all the time.  

Why?  Well, default means you are no longer going to recover the principal (and interest) through the periodic payments since those payments have slowed or stopped.  What that does not mean is the principal (and perhaps interest) is not recoverable at all.  

Enter the idea of equity.  A defaulted loan which carries a 10% Loan To Value has a pretty darn good chance of recovering all of its principal (plus interest).  That is since we have 90% of equity, that equity will afford us the recovery.  

The opposite is not true. A loan with a 110% LTV means the recovery will likely not come from the typical methods and some loss of principal (and all of interest arrears) are not recoverable.

Now for simplicity sake, lets just agree on a given.  A default loan requires advances by the Mortgagee.  Simple enough.  So we can then deduce that any advance made is only made so far as it, itself, can be recovered or by advancing it a greater than otherwise portion of principal will be recovered.  (ie - you need to spend money to get your money back)

With those understands in hand, we can start to carve out some smaller and important distinctions that affect defective loans.  In addition, we can also, or we should also, be able to start to separate loans which are in default but not defective for anything more than performance.

The easiest examples of this idea come from Hard Money Lending.  The loan itself is limited to an equity position which provides sufficient 'room' to recover the advances that will be necessary to enforce the loan.  

How does that relate? Well, a default HML with a 50% LTV and not other defect beside periodic performance likely warrants no further discount. The loan protects itself.

Conventional loans do similar with their down payment or max LTV requirements.  However, they do tend to rely on some portion of the initial loan principal being paid back since conventional allows for a 20% down payment.  In most markets from the onset of default that 20% of equity will not provide the same safety and recover-ability as a larger equity position.

This notion helps us then keep the idea of discount in a little check.  The discount is a function of the cost it takes to enforce and the ability to recover.  

As such, layman conversations which praise purchase prices like "10% on the dollar" or "50% on the dollar" are more meaningless than meaningful.  The statement does not point us to what dollar we are discussing - balance or collateral value.  Therefore the statement lacks any ability to be quantified with any reason or certainty.  

For now, I think that is enough commentary to avoid having to pay rental fees on my post's server space at BP.  The takeaway so far is, the "average" that you think you are looking for is a more complicated set of ideas than the initial question allows.  Until we have those inputs any number given is frankly meaningless.