There are many theories on how to price mortgage notes. Most people have separate guidelines for pricing performing notes and non-performing notes. Typically they pay some % of UPB or BPO for performing notes, and then have other criteria for non-performing. However I think putting notes into 2 discrete buckets is a mistake.
One problem with this is the definition of a performing note can be fuzzy at best. Does ‘performing’ mean that the loan is current? Does it mean that it is current and has not had any missed payments in the last 12 months? Does it mean all of the above and that it has never been delinquent? Or does it mean that the borrower made payments the last 3 months and is 12 months behind? I’ve seen people use all of the above definitions. Shockingly the more strict definitions tend to come from buyers and the loose definitions come from sellers…… Some buyers tend to have such strict definitions that they never actually close on anything because there are few notes on the secondary market that meet their criteria, and if they happen to find one the seller will want an ultra premium for it.
Another problem is that there are many flavors of non-performing notes, and applying a one size fits all approach to pricing is inefficient. Some non-performing notes are only 3 or 4 payments behind, and have had lots of payments in the last year. Others have not had a payment in 8 years and are 10 years behind (which means the property has a good chance of being vacant and trashed). Does it really make sense to price these 2 notes the same way? Obviously it doesn’t, and if you go with this approach you’ll end up having a large % of your offers on quality assets be rejected, and your offers on problematic assets more likely to be accepted. That’s not a winning formula.
A Better Approach
My view is that there is really no such thing as a performing or non-performing note. There are just notes that have different probabilities of outcomes, and different returns associated with each of those outcomes. The outcomes I model are:
- Reperforming on its own or continuing to perform
- Reperforming after loss mitigation and forbearance agreement / loan mod
- Deed in lieu
- Foreclosure
I’ll go into this in more depth next week, but here is a high level overview of the process. Based on the characteristics of the note, I’ll estimate the probability of each scenario. Then I’ll figure out what ROI I would need for each scenario. From there I can back into a price.
Let’s say for example I have a note and I know that it very likely to end up in foreclosure and unlikely to perform. In this case I would want a high ROI for the foreclosure scenario since that is the outcome I am probably going to have. But let’s consider another note that is the opposite, and is very likely to reperform and unlikely to end up in foreclosure. In this case I will be focused on the ROI’s for the reperforming scenarios, and would be ok with a smaller ROI for the foreclosure case because I am less likely to see that outcome.
Of course there will be times where the low probability outcome occurs and you’ll see a smaller return. That’s ok as long as you made sure you had margin. This is a numbers game and some of the low return deals should be balanced by the ones that end up better than expected. If you insist on having large ROI’s for unlikely scenarios and searching for the perfect deal, its easy to end up as one of those folks who never actually close on anything. I have a lot more to come on this subject……