For the last several years private investors buying mortgage notes to facilitate short sales have been a quiet force for effective transactions outside of California. This practice is becoming increasingly more available in California recently as well.
What or who is a “note buyer” and how can they help with a short sale?
To understand these questions, one needs a basic understanding of real estate finance. Pretty much every residential real estate loan in California is represented by two primary documents: a “note” and a “deed of trust.” The term “note” is short for “promissory note.” A promissory note is the basic loan agreement between a lender and borrower. It is ” a note containing a promise to repay” the money borrowed; hence, a “promissory note” or simply “note” for short.
In a real estate transaction, the real property typically serves as collateral for the note. This means that the promise to repay is secured by the real property. Many people think of this a “mortgage.” In California and most Western States, it is more common to use a “deed of trust.” The difference between a mortgage and a deed of trust is beyond the scope of this article. So long as you understand that either one creates a lien that encumbers the property and allows the lender to foreclose, then you know what you need to know for now.
[A short and effective video explaining the larger aspects of the mortgage credit crisis can be found at http://bit.ly/CriCrd . I don’t know the creator, but I will say he has clearly and visually simplified some complex financing concepts.]
Buying and Selling “Notes”
Most notes are designed to be “negotiable,” which means the original lender can sell them to someone else, who can also sell them, on and on. Investors have been buying and reselling notes longer than anyone alive. It’s nothing new. The new angle is applying them to the current difficulties with distressed properties and homeowners.
The person (which can be any kind of legal entity) who holds the note is typically called the “holder” or the “beneficiary.” When an investor buys a note, that investor becomes the new holder or beneficiary.
If the original lender is owed $100,000, for example, and the note has a history of being paid on time and the property securing the note is worth more than $100,000, many investors will pay more than $100,000 for the note because they will receive far more than $100,000 in the repaid principal plus interest. In addition, they are comfortable that they can get all or most of their purchase back if they have to foreclose since the property is worth more than the note.
On the other hand, if the note has a poor payment history, and particularly if the collateral will sell at auction for less than $100,000, then the note will sell for less than $100,000 because there is a high risk that the note holder will have to foreclose and will take a substantial loss.
One can visit www.realtytrac.com to see broad ranges in discounted pricing for properties which sell as short sales and at foreclosure auctions. Short sale discounts can range between 8% to 35% depending on the location. According to RealtyTrac, they typically average close to 20% in California.
Homes that sell at foreclosure auctions usually have even higher discounts. RealtyTrac reports some areas with nearly 70% discounts, although the 30% range is more common. Some high demand areas with “pretty houses” have a small discount similar to short sales.
The key point is that the note holder is looking at potentially a serious loss. They can go through all the costs and headaches of administering short sales and foreclosures or they can simply sell the note and pass the potential headaches to someone else while taking a similar loss.
In many inland parts of California it is not unheard of for a property to have $300,000 of loans against it but now to be worth only $100,000. If the note holder forecloses or permits a short sale, they will take a 66+% loss. If the foreclosure has another 30% discount off the $100,000 non-distressed value, the note holder will recoup only $70,000 on a $300,000 loan – less the costs of foreclosure, eviction and resale which will likely reduce the net below $55,000. Now you can easily see why note holders would sell their notes for a discount.
Enter the note buyer. . .
How Note Buyers Can Facilitate Short Sales
The hypothetical note holder above is looking at possibly netting only $55,000 for a $300,000 note. They might come out “ahead” if they sell the note for $80,000, for example. They will reduce their potential loss by $25,000.
The new note holder, or beneficiary, now has an entirely different dynamic than the prior note holder. They paid $80,000 for a note secured by a property worth $100,000 if the note wasn’t in default or the property wasn’t in foreclosure. If the new beneficiary approves a short sale for $90,000 (with 8% closing costs or $7,200), they were just paid $82,800 for a note they bought for $80,000 and made $2,800.
You can see how a note buyer who just purchased a note at a discount can be much more friendly to a short sale than the prior note holder: the prior note holder was looking at losses, while the new note holder is looking at possible gains.
Note Buyers Impose Fewer Short Sale Restrictions
Existing note holders who will take a potential loss on a short sale or foreclosure often impose restrictions that they think will help reduce their losses. These restrictions include: prohibiting the current homeowner from renting the home after the sale; prohibiting a family member or business associate from purchasing the home; prohibiting the homeowner from buying back the home in the future; and, prohibiting the buyer from reselling the property for anywhere from 30 to 120 days after purchase, even if it needs substantial repairs and rehabilitation that can be completed faster than that.
Although these restrictions are often irrational and ineffective (even counter-productive) to increasing the return to the note holder, they are an unfortunate reality of the market.
Most note buyers, on the other hand, do not impose these restrictions. Since they are looking at possible gains instead of losses, they are typically motivated by rapidly liquidating their note investment and moving on to making more of them. This creates a larger pool of buyers and quicker closings for short sales. It also provides seller with opportunities to stay in their home and even to buy it back in the future – unlike the big bank servicers.
I have had many business contacts buying notes in other parts of the country where smaller lenders hold more notes which were not securitized and who are more willing to sell one at a time. California had been dominated by large lenders who repackaged and resold large pools of loans (as explained in the video I cited above). These large lenders then service these loans and usually are not willing to sell one or two notes at a time. They want to sell whole pools, or at least larger lots of notes.
As the mortgage crisis has lingered on, more investors have developed the funds and abilities to purchase larger lots of notes. These investors are often referred to as “aggregators.” They aggregate the demand for one or two notes into ten, twenty, thirty or more which the large banks and servicers are more willing to sell. This has brought the prospect of a “friendly short sale” to California.
How Does It Work?
Different investors handle note purchases in slightly different ways, but the common qualities are that they use some form of marketing which asks homeowners to identify themselves as wanting a short sale. The homeowner then applies for consideration to have their note purchased. If the circumstances fit the investor’s requirements, the investor adds that note to the group they want to purchase and then negotiates a large lot purchase from the note servicers and note holders. Once the investor owns the note, they permit the friendly short sale.
(One can also imagine how this approach could be used to re-finance an existing loan that an investor buys at a discount thereby creating equity, but that process is beyond the scope of this article.)
Is it Legal?
When something good comes along, the first question is often: “Is it legal?” That question is phrased backwards. It should be: “Is this illegal?” Laws are made to define what is illegal, not what is legal. There are far too many kinds of behavior that would need to be defined as legal. So one must look for specific laws that might be violated.
The basic steps of buying and selling notes is a long established commercial practice – as I have said, older than anyone alive. Liquidity in the financial sector is built on the process. It is generally referred to as the “secondary note market.” Since it occurs between investors and financial institutions, it is not an issue of consumer protection. The consumer is primarily affected only by who is servicing the collection of payments. There are laws governing the notice of changes in servicers, etc. but those don’t directly impact this process.
The “packaging” of notes into investment vehicles is a “securities” transaction. Securities transactions are regulated generally in two respects: (1) sales to individual investors; and, (2) regulating persons who represent investors in certain investor-to-investor transactions. The typical note purchase involves an investor who is acting as a principal on its own behalf. There is no resale of the note to the public; hence, (1) does not apply. There usually is no one acting as an intermediary for the investor, so (2) does not apply. (If an investor is using an intermediary, then the investor needs to assure that the representative is properly qualified, but that does not affect the homeowner in any way whatsoever.)
Is it subject to SB94 or MARS?
There are two main sets of laws governing loan modification and other mortgage assistance relief services. California has a series of laws that were adopted by Senate Bill 94 (2009) which amended various provisions of the California Civil Code and Business & Professions Code. Essentially, SB94 prohibits providers of loan modifications and similar services from collecting advance fees. They must successfully complete a loan modification for their “client” before they can be paid anything.
There is also a set of federal rules promulgated by the Federal Trade Commission generally prohibiting the payment of advance fees and requiring certain notices in connection with “mortgage assistance relief services” (hence “MARS”) such as loan modification.
A note purchaser, however, is not the provider of note modification or other foreclosure relief or mortgage assistance relief services. In these services, there are three participants: the borrower, the current note holder, and one I’ll call the “consultant.” The “consultant” acts as a representative of the borrower in communications and/or negotiations with the note holder to try to obtain some kind of relief for the borrower. The “consultant” is the person these laws are striving to regulate. Since the bank servicing the note holders rarely approve worthwhile relief, the legislators and regulators didn’t like having borrowers pay a consultant in advance for relief the banks would not likely award, so they made advance fees and guarantees illegal.
In a note purchase there are also three participants: the borrower, the current note holder, and the potential note buyer. The key difference is that the note buyer is NOT acting as a representative of the borrower, but on its own behalf to see if it can purchase the note at a sufficient discount. There are no “negotiations” on behalf of the borrower nor any kind of “representation” of the borrower. So an essential requirement of being subject to SB94 or MARS is not present because the note buyer is not acting on behalf of the homeowner/borrower.
It can certainly be soundly argued that a note buyer who collects an advance fee is not rendering services covered by these laws, but I would discourage homeowners from working with investors who demand an advance fee. The investor is in the transaction for the investor’s benefit, so the investor should take that risk.
On the other hand, the investor needs to decide which notes it wants to purchase and which it does not. For that, the investor must conduct its own “due diligence” investigation. The investor needs to have a reliable valuation of the property and needs to know the borrower’s payment history, creditworthiness and/or hardship. This information helps the investor negotiate the discount with the bank.
Obviously, investors must pick and choose between notes to purchase and should do so on a rational basis. Hence, it is rational for them to require the borrower to provide an appraisal (or independent broker’s price opinion), credit report, loan history and personal financial statement. Most homeowners don’t have this readily available, so it would not be unreasonable for an investor to provide the homeowner with the means to acquire the data at cost. Otherwise, investors would be deluged with applications and speculatively incurring costs that would be prohibitive and the opportunity for borrowers would be very limited or non-existent.
So long as there is merely a cost reimbursement or pass-through, the investor is not benefitting at the borrower’s expense, as is the case with an advance fee and inadequate services.
Accordingly, I would advise a homeowner that covering the costs of the investor’s due diligence is not unreasonable. The investor should be prepared to itemize costs and identify service providers if asked by the borrower.
Once the investor purchases the note, the investor re-structures the note terms on its own accord, no one is negotiating with the new note holder and no one is representing the borrower. Civil Code Sections 2944.6(d) and 2944.7(c), enacted by SB94, exempt from its provisions “a person, or an agent acting on that person’s behalf, offering loan modifications or other loan forbearance services for a loan owned or serviced by that person.” Accordingly, the note holder’s decision to restructure the note does not appear to be subject to SB94 nor to be under the jurisdiction of the California Department of Real Estate.
The Role of Real Estate Agents
The note buying process can, and often will, involve a fourth participant: a person who informs the borrower of the opportunity and connects the borrower and the note buyer. This is often a real estate agent since they are typically the primary information provider for consumer real estate transactions.
A real estate broker or agent (“licensee”) has a duty to be fair and loyal to the homeowner. If they know there is a good, non-real estate solution for the homeowner, the duties of fairness and loyalty should obligate the real estate licensee to inform the homeowner of the existence of the opportunity. The homeowner should be directed to sources of sufficient information to decide between options such as a traditional short sale negotiated with the bank or requesting a “short sale friendly” note buyer to buy the note so there isn’t a big battle for the short sale approval.
I’ll refer to the “friendly short sale” as a “non-short sale” and hope that I’m not violating anyone’s intellectual property rights. It is a “non-short sale” because the new note holder is not taking a short payoff. They are actually being paid more than they purchased the note for – unlike the prior note holders who must take a discounted, or “short,” payoff.
This can be mutually beneficial to the homeowner and the licensees involved. The short sale proceeds with less trouble, without the adversarial nature presently involved in attempting to obtain discounted payoffs.
Obviously, some investors would want to create incentives (compensation) for real estate agents to not only inform borrowers about the opportunity for a non-short sale, but to identify the particular investor and to apply with that investor. Since the real estate agent is making a referral with respect to a transaction which does not appear to be under the jurisdiction of the Department of Real Estate, any referral compensation would not appear to be a “real estate commission.” Nevertheless, for the borrower’s benefit, I would encourage the borrower to find out if the real estate agent is paid simply on the referral or based on the success of the transaction. It is far better in my point of view if the payment is based on a successful transaction so that the licensee’s incentive is to refer to a note buyer who will close transactions, not just who pays referral fees.
When the non-short sale closes, both the listing agent and the selling (buyer’s) agent receive their normal commissions. Most note buyers I have heard about do not attempt to reduce the real estate agent’s commissions like the bank servicers sometimes do. Also, since no “negotiations” are involved, there are no issues about who pays the “short sale negotiator.” This makes the non-short sale much more of a win-win-win situation for the seller and both real estate agents. It also can be a “win” for a buyer who would like to rent back to the seller or eventually sell back to the seller – or resell the property on the market in a short time.
Help For Distressed Homeowners
This article is already quite long and is merely an initial overview of the non-short sale note buying process that is beginning to work its way into California from other states – which is the reverse of most other trends. The anecdotal information I’ve received from investors and real estate agents in other States indicates that it is strongly a win-win-win proposition for the homeowner, real estate agents, buyers – and even the current note holders who liquidate a toxic asset.
Many people have been looking for “government solutions” to the “housing crisis.” Few understand that there are effective private solutions. Discount note buyers are in a position to provide principal reduction of existing notes and simplified, non-restrictive short sales, while actually reducing losses to existing note holders — all without government subsidies and taxpayer bailouts. This also reduces foreclosures and the questions about improper foreclosure practices.
As with all newer business methods, homeowners need to seek out expertise. Agents who don’t know about note buying are likely to make negative statements out of ignorance or out of fear of competition. The rational response of California real estate licensees should be to seek valid information, embrace the concept and align themselves with resourceful, non-short sale friendly investors. The increasing skills and resources of note buying “aggregators” appears poised to provide a new means of true relief to distressed homeowners and a private stimulus to recovery of the housing market.
As always, comments are welcome and invited.