New and Interested in Buying Banknotes

[Sarah Junker]

Hello, my name is Sarah Junker. I am young and wishing to learn as much as I can as to how to break into the real estate world. To begin, I have chosen to look into how to buy banknotes then find investors to sell them to. Any advice is much appreciated!

[Dion DePaoli]

Sarah,

It is good you are trying to learn, no harm in that.  Also, I don't want to steal @Don Konipol thunder but he is trying to give you a little bit of a reality check.  (Usually I am Debbie Downer so it's a nice break)

Do not confuse what your father does in his realty dealings with trading loans.  Once a loan is originated the terms of the loan are set.  They can not be amended at the whim of a buyer and seller of the note and security instrument.  The loan is made, that is what is bought and sold.  The loan can not be amended without the approval of the borrower.  

While there is a lot of chatter about being able to purchase loans from a bank, I would tell you with over a decade of experience in secondary market those deals are very few and far between for street level investors.  That is sort of what I believe Don was alluding to.  

It will be beneficial for you to go learn a bit more about how our current market works in regards to financing and capitalizing loans.  Residential loans are often originated with the intent to distribute the risk by selling the loans in large pools into the secondary market.  Generally speaking the largest investors in the secondary include Fannie Mae, Freddie Mac and Ginnie Mae.  Loans not sold off in the secondary market which are held by the originating institution are called "portfolio loans" while loans that are sold off are called "agency loans".  Meaning they are originated with the intent to sell to one of the agencies I mentioned.  Sometimes also called "conforming" loans, meaning they conform to the underwriting guidelines of those agencies.   

The majority of the some $9 Trillion mortgage market are loans that are not sold at a discount.  If we pause to contemplate that, hopefully it makes a little sense.  If you continually made loans for 100% and sold them for less than 100% you would run out of money rather quickly.   So the other implication there is loans that do sell for a discount have some type of defect about them.  Those defects can vary widely from minor issues to major issues.  As such, the discounts will vary accordingly from small to deep.  Nonetheless, discounted loans are a small piece of the overall mortgage secondary market.  Albeit, a portion of the overall market at less than 10% is still a pretty big number.

A bank or financial institution has no mandate to take a loss, which is what selling at a discount would mean if they made the loan.  Further, their cost of capital is far cheaper than that of most private investors.  This allows them to mitigate their losses on those loans better than selling to a private investor who is going need a steep discount to achieve their desired rate of return.  As an example, the big banks are happy to earn 3.0% while a private investor seeks 10%.  That is a pretty big gap to fill.  In addition, the likely counter-party for a financial institution who seeks to sell defective loans is another institution with a similar cost of capital which in turn minimizes the discount on the loan.  Probably the largest and most apparent barrier there is.

In addition to that and contrary to what @Scott Carson is saying is that local community banks have a charge off and default rate on loans around 3.0%.  That includes all loans and if we drill just into residential loans the charge-off default rate is around 4.5%.  A very manageable number.  We can actually see how manageable it is by noticing the dip in all loans vs the increase in just residential loans.  Banking nowadays is not all about residential loans.  Local banks plug a lot of resources into business and commercial banking.  That is more of their bread and butter.  Residential loans are ancillary not primary business nowadays.  These are not George Bailey banks anymore.  Further, you will not pass any type of counterparty risk assessment for any of the big banks and likely not for the regional banks either.  

All of this should be fairly intuitive if we understand the actual market and how the players operate.  Local and community banks are intimate with their loans and their loan production.  As such, we would expect lower default rates and those loans that do default are generally handled in house so the bank can best mitigate its loss.  There is very little incentive for a community or small bank to sell to a street level investor who wants steep discounts and poses headline risk for the bank.  The loans that are trading are still legacy loans with vintage (age) of the mid to late 2000's.  So stuff from 2007 to 2010 with a diminishing inventory in later years.

Last but not least, those types of institutions have a duty to their shareholders, that if they did need to sell for some reason they would be required to put the loans out for auction to obtain the highest and best price for those loans possible.  This would mean they get auctioned off by DebtX, First Financial, Garnet Advisors or some of the broker-dealers that have trade desks and books of well capitalized buyers.  It would not be in their best interest to simply take the loans and sell them off to the first person who called or walked in off the street wanting to purchase loans.  There is a bit more to it than that.  

None of that is meant to discourage you but rather nudge you toward getting a little more knowledge about the industry that has sparked your interest.  There is much to learn.  Like anything, many folks have answers but that doesn't mean they are the right answers.  Good luck.