(ALMOST) EVERYTHING THAT COULD POSSIBLY GO WRONG WITH A NOTE – AND HOW TO PROTECT YOURSELF
by W.J. Mencarow, President of The Paper Source, Inc.
Copyright 1999, The Paper Source, Inc. All Rights Reserved.
Your First Question
There are many litmus tests used to assess the risk of a note. Primary factors include the type of property securing the note, the loan-to-value ratio (or more accurately, the investment-to-value ratio), the strength of the local and/or national economy and the payor’s financial strength.
Whenever you consider a note, ask yourself, “would I want to own the property securing this note?” If the answer is “no,” don’t buy it.
I’m not saying you should want to live in the property: it’s an investment. But assume you’re buying the actual property (after all, it’s possible you may have to foreclose). Ask questions such as:
What’s the state of the local economy?
Is the property’s value dependent upon just one or two big employers (who might have lay-offs, strikes, shut-downs, etc.)?
Is the area growing? Stagnating? Regressing?
What is the unemployment rate? How does it compare to five years ago?
How have property values changed in the past few years?
Currently in this community what is the average time a property is on the market before it sells? How does that compare to a year ago? Three years ago?
Could I afford to have it on the market for sale, unoccupied, for this period?
Does the property fit in with my investment objectives?
Is it completely different from any other properties I own?
Will it cash flow?
Does it need major work?
Does it have major design flaws?
What kind of neighborhood is it in?
How much would it cost to foreclose?
What methods would I use to sell it at a profit in a bad market?
Is it a single family house, a condo, an apartment building, a factory, vacant land, a sushi restaurant?
If I had to foreclose, what would I do with a single family house, condo, apartment building, factory, vacant land or a sushi restaurant?
Beware of These Properties
Unless you’re an experienced paper investor, stick to notes secured by single family houses, preferably owner-occupied. An owner-occupant is less likely to risk foreclosure than is an investor.
The bulk of your portfolio should be in good notes secured by properties that can be sold relatively quickly. Notes secured by apartment buildings, commercial property, lots, raw land, etc are risky.
Raise your equity requirements for condos, and stay away from paper backed by co-ops. They aren’t actually real estate, and they don’t normally appreciate like it.
The notes you select for your own portfolio should be anchored by well-secured residential properties in good locations.
Don’t be cavalier about foreclosure. Some people will tell you, “So what if you have to foreclose? You just get the property.”
That’s sheer ignorance: you don’t “just get the property.” Foreclosure can be a long, drawn-out affair involving lawyers, legal notices, fees, damaged property, bills, sheriffs, court hearings, more fees, vacant property, plumbers, electricians, carpenters, more bills, more court hearings, lost investment income, more fees, more bills. . .
In most states there’s something called “the right of redemption.” If you’ve never heard of it, I’m impressed; that means you’ve never been involved, on either side, in a foreclosure, and that’s to your credit. The right of redemption means that the defaulting mortgagor (the one who won’t pay you – the bad guy) has a statutory right to buy back his house for a certain period after foreclosure. Sit down: it’s a full year in some states. That ties you in knots, legally and gastrointestinally.
If you obtain the property for less than 70 percent of market value the former owner may be able to set aside the sale as a “fraudulent conveyance” under the bankruptcy laws. Also, your ability to get title insurance may be limited.
Will a Deed in Lieu Avoid Foreclosure?
Some people advocate a “deed in lieu of foreclosure.” The mortgagor signs over the deed and a quitclaim to the property to you which supposedly avoids the mess of foreclosure and “saves his credit and good name.”
Will a deed in lieu avoid foreclosure? Maybe, maybe not. At least one court has ruled that such a deed is an “equitable mortgage” and the mortgagee still must foreclose.
Still, suppose the mortgagor simply gave you his deed to prevent foreclosure. Wouldn’t that be much better for you? Not necessarily. If you accept a deed, you must honor any liens junior to yours. That means that if you own the second lien and there’s a third, forth, etc., if you don’t foreclose and instead take a deed in lieu of foreclosure, you must make the payments on those notes. Foreclosure would have wiped them out.
If you’re ever faced with that situation, contact the mortgagees junior to you and offer to buy them out at a price that would be less than what foreclosure would cost you. Just explain that foreclosure could cancel their notes completely, and your offer will at least give them something.
There’s another potential problem with accepting a deed in lieu. If I were an attorney representing a client who had given a deed in lieu of foreclosure, I might try suing the mortgagee (that’s you) on the theory that by requiring (or even accepting) the deed you deprived him of his right of due process under the law.
Will a deed in lieu save the mortgagor’s credit? No. The FNMA/FMAC loan application, the standard of the industry, asks, “Have you had property foreclosed upon or given title or deed in lieu thereof?” Gotcha.
Foreclosure fees vary by state and locality. It’s a simple matter to ask a local attorney how much it would cost and how much time it would take (in the worst-case scenario) to foreclose on the note you’re considering. Apply these charges to the cost of the note.
Then you must factor in the costs of the legal delays involved in foreclosure. For example, you may have to hire an attorney to get the property out of the jurisdiction of a bankruptcy court. The time required to foreclose is affected by many factors: by state law, by whether a bankruptcy is involved, by the type of bankruptcy filed, and other variables. You should count on six months to, in some states, even a year of lost income on your note.
Remember, if you hold a second position note you’ll have to make up the missed payments on that as well as any late fees and attorney’s fees the first lien holder incurred. Then decide how much you will pay for the note (some people even use this figure to calculate the investment-to-value ratio: more on that later).
The Foreclosure Formula
In deciding to foreclose, you add up your costs and compare that to the equity in the property. Here’s the math: your original investment in the note + the amount of back payments owed you + foreclosure fees + your lawyer’s fees + bringing any superior liens current (including late charges and their lawyer’s fees if they start foreclosure independently of you) + back taxes + tax penalties and interest + repairs to the property + painting, carpeting, new appliances or other cosmetic improvements to make it marketable + real estate agent’s commission + current taxes + insurance payments + payments on the superior lien while you try to sell the house + closing costs + the value of your time fooling with all of this…and don’t forget several months of lost income on your note investment during foreclosure.
In case of default, you must be able to pay the costs of foreclosure and pay off the senior lien or make the payments, whichever is required. That’s why virtually nobody will buy a small second behind a million-dollar first lien. Most buyers look for a ratio of 1:3 to 1:5 in the size of the second to the first depending upon the monies involved. there are a few investors who will buy small seconds behind large firsts: They are in THE PAPER SOURCE REGISTRY OF NOTE INVESTORS, sent to all PAPER SOURCE JOURNAL subscribers. See the website www.PaperSourceOnline.com for information on obtaining the Registry.
If you couldn’t afford the costs of actually owning the property (including making the payments on the first lien while you are trying to sell or rent it), or wouldn’t know what to do with it if you did own it (such as industrial property), don’t buy the note.
The bottom line: have plenty of equity in any note you buy.
If you couldn’t afford the costs of foreclosure, if you couldn’t pay off the first lien or make the payments on it (only count on doing this if it’s assumable), or if the fees and “hidden costs” of foreclosure would consume your equity in the note, don’t buy it!
If your mortgagor is even one day late, send him a tough warning letter (via certified mail, return receipt requested). Pull no punches with late payors – if you are soft, they’ll pay later and later every month (if they pay at all), you’ll lose more and more money and you’ll end up foreclosing anyway. Remember, the longer you carry them, the deeper in debt they’ll get. By being “kind,” you’re just digging their financial grave.
“Mr. Landlord” newsletter printed “10 Reasons Why You Should Not Feel Guilty About Eviction,” and I’ve modified their list for note holders. If you’re tempted to operate from your heart rather than your head, you need to consider this:
10 Reasons Why You Should Not Feel Guilty About Foreclosing
1. If the payors need extra time, the court will give it to them. Always start foreclosure immediately.
2. Your profit is in owning the mortgage, not the property. Foreclosure and property ownership and sale is expensive and time-consuming.
3. You have already supplied the “needy” payor with free housing. You’ve done your charity work, now give someone else a chance.
4. If the payor doesn’t have a friend or relative to help him out, doesn’t that say a lot about his character?
5. If anyone asks you how you could put someone out on the street, ask them to make the payments for them.
6. The delinquent payor has broken his word, violated his contract and is stealing from you. By remaining in the house but refusing to make his payments he is a thief. Do you see stores letting people come in and take from them?
7. Letting a mortgagor stay in the house who is not making payments is like giving him your charge card or a blank check and saying, “Feel free to spend it, I really don’t care. I like lending money out interest-free, even if I’m not sure I’ll get it back.”
8. How would you feel if you worked all week and your employer told you he couldn’t pay you? Well, your mortgagor has told you that. Do you work for nothing?
9. Your delinquent payor is taking money that keeps you from proving for your family’s needs. And the sad thing is some deadbeat mortgagors live better lifestyles than their mortgagees. It’s easy when the mortgagee lets them live there without paying! Picture yourself telling your child that you cannot give them what they want because you had to make a stranger’s house payment so the stranger could buy a gift for his child!
10. IF YOU WANT TO PROVIDE FREE HOUSING FOR SOMEONE, YOU SHOULD BE THE ONE WHO DECIDES WHO GETS IT.
Assuming this section scares you silly, as it should, know this: I’ve been involved in paper since 1981. I’ve had plenty of defaults, but almost all were cured in time. I’ve only had two go into foreclosure.
You should always make sure you have enough equity in every note you own so that foreclosure, even after all the costs, would be profitable. The time to make sure of that is when you buy the note.
The Cornerstone of Risk Analysis
The investment-to-value ratio (ITV) is about the most important information you can have about a note. It is indispensable when calculating risk. You hear a lot about the loan-to-value ratio (LTV), but not much about the ITV. Both are expressed as a percentage. The LTV is the balance of all outstanding loans against the property divided by the market value of the property. For example, a $100,000 house with one loan of $80,000 against it has an LTV of 80 percent (80,000 divided by 100,000).
The difference is that you use the price you are paying for the note to figure the ITV, not the face balance, since the money you have invested is what’s important. Suppose you bought that $80,000 loan for $50,000. To calculate the ITV, divide the price you pay by the market value. 50,000 divided by 100,000 equals 50 percent. Your ITV, your actual risk (sometimes called “exposure”) is 50 percent.
The higher the ITV, the riskier the investment. Most investors won’t touch a note over 90 percent ITV, and many won’t consider anything over 80 percent. The costs of foreclosure, legal fees, curing the senior lien, property repair costs, holding and marketing the property, opportunity costs (what you could have been making on your money if it hadn’t been tied up in a defaulted note) and other factors, plus the original cost of the note, could eat up that cushion and well exceed the total value of the property!
Conservative ITV guidelines are: no more than 75 percent on a single family house or an apartment building with four or fewer units; 65 percent on larger apartment buildings, commercial or industrial property; 50 percent on raw land or a single family house outside your local area; 40 percent on mature, developed lots in recreational areas. Venture beyond at your own risk.
Improvements made to the property will improve your ITV and thus your security. So will the effects of amortizing the debt against the property, since this produces equity. As the property securing the note appreciates, your risk diminishes. And vice-versa!
There are other ways to reduce the ITV of a note. A powerful technique is to buy part of the note (a “partial”). By purchasing the first sixty payments, for example, of a thirty-year note, you significantly reduce the ITV and your risk.
Another method is to use a blanket mortgage, which covers more than one property. You’ll learn a lot about partials, blanket mortgages and many other techniques as a PAPER SOURCE subscriber.
What is the purpose of the LTV then? It is useful in helping to determine the likelihood that the note payor will default. For example, the LTV of a $98,000 note on a $100,000 house is 98 percent. If you buy that note at the deep discount price of $60,000 your ITV is only 60 percent. Is this a safe note? Possibly not, since the payor has virtually no equity in the house and may decide he has nothing to lose by defaulting.
There Are Appraisals, And There Are…
An appraisal is only an opinion. You hope it is an informed opinion. The more the appraiser knows his business, the closer to “true market value” he can come.
Don’t take anyone’s word for the value of the property. If you aren’t intimately familiar with local values, get a professional appraisal. Don’t rely on real estate sales comparables (and especially not on asking prices for unsold property!).
Get an appraisal in writing. If it’s not in writing, it’s not an appraisal.
If you’re using your own appraisers, make sure they’re certified by one of the nationally-recognized agencies such as the Appraisal Institute, indicated by the designations M.A.I. (Member, American Institute of Real Estate Appraisers or S.R.A. (Senior Residential Appraiser, Society of Real Estate Appraisers) certified (the two organizations merged on January 1, 1991 to form the Appraisal Institute, but their members still use the abbreviations).
The membership directory of the Appraisal Institute is very handy when you need an appraiser. Call 1-312-335-4100 for a free copy.
When you call an appraiser, the first thing you should tell him or her is the type of property to be appraised. Many appraisers only work with one type, such as commercial or residential property.
Typically, residential appraisals cost between $150 for a “drive-by” report of 1-2 pages with no comps, to $300-$400 for a full-blown “walk-through” inspection supported by comps and photographs. You can compromise for about $200 for a drive-by with comps, or about $250 for a walk-through without photos.
If you’re buying a note from a broker, don’t use his in-house appraiser. Insist on your own.
An appraisal on a property that has few or no comparables, or where the last sale was a year or two ago, is at best an educated guess. How do you judge an appraisal? Here are a few tips:
* Be sure the appraisal is current. Don’t accept any appraisal more than 6 months old.
* Look at the values of the comparable properties. If they are all lower than the appraised value of the subject property, it may mean that the area doesn’t support a value that high. In other words, people with that much to spend would probably prefer a better neighborhood.
* Closely related to this is an appraisal showing one comp at one price and several comps a couple of blocks away at significantly higher prices (“comp” is short for “comparably priced property”). They are probably located in a more desirable neighborhood and should be adjusted downward. All other things being equal, the subject property is closer in value to the first comp.
* Discover what the present owner paid for the property. If he bought it relatively recently (within the past year or two) at a price far below the current appraisal, that’s reason for caution.
* Compare the prices of comparable properties that have not sold but have been listed for a long time. If the subject property appraisal is at about the same price as a number of comps that haven’t sold, how likely is it that you could sell the property for the appraisal price if you got it in foreclosure?
* Compare the sold comparable prices. Sometimes one house will sell for far more than market value. A house in my neighborhood recently sold for almost $50,000 more than any comp had ever sold before. The owner of the house next door had his for sale within a week for $20,000 over that price! It sat on the market for 6 months while other houses in the area sold at realistic prices, and he finally gave up.
Why that house sold for so much is anyone’s guess, but to base an appraisal on it would be ridiculous. A good appraiser would ignore it.
* A picture may be worth a thousand words, but it is worth a lot more in dollars if it shows a significant difference in the condition of the subject property and the comps. Be sure the appraiser has adequately adjusted for the condition of the property, up or down.
I cannot stress it enough: the value of a note depends ultimately upon the economic conditions that support the value of the property. Monitor the economy of any area in which you have a property interest. If it’s a depressed area but you still think it’s a good investment, just lower your maximum acceptable ITV levels.
For more information, consult “Tips on Real Estate Appraisals,” available for $1 from the Council of Better Business Bureaus, 4200 Wilson Blvd., Arlington, VA 22203-1804.
Should You Buy Notes Out Of Town?
Unless you are optioning notes for resale to a professional, or you are a seasoned paper investor, buy notes only on properties within a comfortable drive, an hour or two, from your home.
Do not solicit for notes in another state unless you are appropriately licensed in that state (if required – see the section on licensure and solicitation that follows). It’s safest to know your own state’s requirements and only do business there.
Optioning notes for resale is discussed in detail in my guide, “How To Get Started In The Note Business.”
Seasoned paper investors (and I define a seasoned investor as one who has personally negotiated and bought over 100 notes for his own portfolio) should be extremely careful when purchasing notes out of their own area. If you qualify as a seasoned paper investor, there are only two and a half conditions under which I would advise you to buy out-of-town paper (yes, I’ll explain):
1. Paper secured by property in those locales with which you’re very familiar. For example, you may visit certain areas on a regular basis and can keep up with changes in the local economy.
Remember that the value of a note depends ultimately upon the economic conditions that support the value of the property.
You must keep abreast of those conditions in order to properly monitor your investment, and that’s why out-of-town paper isn’t appropriate for most people.
2. As a partnership. If there is someone you trust who is knowledgeable about paper living in the area in which the property is located, you can enter into a partnership agreement to buy paper with the provision that your partner will to step in and buy you out if something goes wrong. The best way to arrange this is to have the buy-out provision in the written contract (do not attempt this without a written contract).
2 1/2. Rock-solid first lien deals (including loads of equity) on desirable owner-occupied homes. Keep your investment small (“small” = whatever you can afford to lose without terrifying yourself) and keep the number of these notes small in relation to your whole portfolio.
For valuable information on each state’s laws, get a copy of “Real Estate Practices – State-by-State.” It’s available at no charge from First American Title Insurance Co., 114 E. Fifth St., Santa Ana, CA 92701, 714-558-3211.
Do You Need A License To Do This?
If you live in California or another highly-regulated state, you will need a license to buy and sell a number of notes. You may even need one to deal in options to buy notes. Since there are 50 different states with laws that are constantly changing, you would need a staff working full-time just to keep up with them.
To determine your state’s licensure requirements, contact your state’s banking, real estate or corporation commission (the appropriate department goes by different names in different states).
When you ask, make sure they understand that you are not originating mortgages, since that’s what “mortgage broker” means to most people. If you will not be actually buying the mortgages before resale – if instead you will be simply assigning purchase contracts – make that clear as well.
If you don’t like the answers you get, or if the person seems unsure, wait a few days, call back and talk to someone else. It wouldn’t surprise me if you get a different answer! If not, try again later. When you have the answer you like, get the name of the person you talked with and write them a letter asking the same question. Your objective is to get the answer you want in writing.
Does this procedure seem strange to you? It is, but that’s how to deal with a bureaucracy. Take it from a former federal bureaucrat.
If your state does regulate what you want to do, Secure a copy of the applicable laws and read them. You may find that they don’t apply to what you are doing. For example, the law may define “mortgage broker” as I did above, someone who originates mortgages, and it may say nothing about buying and selling existing mortgages. Double-check your conclusions with a good attorney.
Here’s something almost everyone forgets to do: Always be certain that any required licenses exist for the people who originate loans you buy.
Use a Note Analysis Worksheet
Whenever you’re offered a note, reach for your note analysis worksheet. This will help you to systematically remember all the questions you need to ask and will tell you almost instantly if this is a note for you.
A computer program called NoteWorks is now available that makes this task much more efficient. Call 800-526-5588 or visit www.notesmith.com for information.
Learn About Origination
Learn as much as possible about how the note was originated. Why was the loan made? Was it a homeowner, borrowing from a fly-by-night high interest rate lender, to stop a foreclosure on his home, but the loan was called a “business” loan? (See “The Most Ignored Risk Factor Of All” in this guidebook.)
Was it closed by competent people? Was everything mentioned in this book checked out? If the loan was originated by someone who did not have a required license, your new note could be uncollectable and worthless.
If you’re thinking of buying a newly-created purchase money mortgage at the settlement table, be careful. If your yield (which includes any points paid to you) is above the statutory usury rate and the transaction is determined to be a loan your note would in all likelihood be made null and void by the court.
Here are some steps you can take to protect yourself:
1. Establish via a notarized letter from the seller that your funds are not a loan and that he is ready, willing and able to close the transaction without your purchase of the note. Keep this letter in a safe place.
2. In earlier editions of this book, I said, “Put some distance between you and the property sale. Do not purchase notes at the settlement table. Wait at least a month (or until a payment has been made), preferably longer.” While that’s still good advice – The Associates, the largest consumer finance company in the world, does it – it has no effect on whether or not the transaction may be characterized as a loan. I no longer would advise someone to refrain from purchasing notes at the settlement table as long as their documentation for the transaction was tight and as long as they have not had any communication, directly or indirectly, with the note payors.
3. Do not solicit real estate brokers and agents to buy notes with language — especially in writing — indicating you will “fund” the transaction or otherwise indicating that your monies can be instrumental in closing a property sale. It’s all right to explain how the creation and sale of a note can expedite the sale of the property, but make sure you don’t use language that could be construed to mean that you or your investor would be lending moneyto make the property sale possible.
4. For the above reasons, name your business something other than a “funding” company. That sounds too much like you originate loans: Why make the elementary mistake of giving a name to your business that is a red-flag to regulators? In the same vein, don’t use your own name in your business name. Keep as low-profile as possible. And it should go without saying that unless you have the necessary licenses and trnasaction registrations to solicit and sell securities, don’t use the word “securities” in your company name.
Verify the Payment History
You need to know if you’ll be paid on time. One clue is to see how prompt the payor has been in the past. Since almost every note seller says the payments are always been made on time, if not before, ask him for “third party verification” such as copies of canceled checks, bank deposits or his bank statements showing the dates the checks were deposited.
If he asks, “don’t you trust me?” just say, “of course I trust you, but I may be placing this note with an investor who insists on this information.” If you don’t want to mention that you’ll be using an investor, just tell them that it is your “corporate policy” to get that information. (Jimmy Napier taught me that.) It’s amazing what you can get when it’s not you asking, but your corporate policy. Don’t do business with someone who refuses to cooperate no matter how great the deal sounds.
The task of verifying payments is made easier if a bank or escrow company has been servicing the note, so remember to ask if that is the case.
Here’s a secret that 99 percent of paper buyers – even the professionals – overlook: always check the payment history of the first trust. It’s a litmus test as to the reliability of the payor. The credit check should indicate any serious problems with it, and you can also get the information from the first trust lender if you have a signed authorization from the payor.
Having said that, let me point out that far too much is made of the alleged desirability of notes with payment histories (called “seasoned paper” as opposed to “green paper”). All other things being equal, pick a seasoned note, but remember that the payment history is no guarantee of future performance. It becomes irrelevant if the property is sold and your note is assumed by someone else.
That’s why the best notes have enforceable due-on-sale clauses. It’s your option to enforce the clause, and you can do what you wish within the law; charge an assumption fee, raise the interest rate, demand a lump sum principal payment, whatever your creative mind dreams up, because you are in control.
How Much Down?
Earl Woodell was a good friend of mine, a real estate broker in San Antonio who was also one of the first and certainly one of the most active note buyers in Texas. (Earl passed away a few years ago.) One of many Earl Woodell gems is this: “The amount of the down payment is inversely proportional to the note’s propensity to default.” In other words, the less down, the more likely it is to go belly-up. Earl said that most of the zero down or $1,000 down notes he bought defaulted.
A large down payment is good security for you. It means the note payor has his hard-earned cash invested in the property and is less likely to default on his payments. This is especially true for an owner-occupied property. At the least, it means that sometime in his life he was able to put together a lot of cash, and that says something about him.
Of course, make sure that the downpayment was cash, and not rent credits, a car or anything other than real money. I once was offered a note where the downpayment was “valuable gemstones.” I passed.
Get a Credit Report
If you buy mortgages or trust deeds, you’re in the credit business. You’re lending your money, and you should take every precaution available to you to protect your capital. Just because you may be an individual or small business is no excuse to be lax in this responsibility.
In fact, if you have investors or partners you have a fiduciary responsibility – a legal and moral obligation — to use every avenue at your disposal to insure that their funds are invested prudently. Reviewing the credit reports of note payors is an important part of that responsibility.
It’s vital to get a credit report on the payor before you decide on the note. Does he pay his bills on time? Have any creditors turned him over for collection? Any judgments against him? Any unpaid judgments? Is there any pattern to late payments? What is his occupation? Job stability? Cash flow? How long has he lived at his current and previous addresses? What is his income pattern? How old is he? Does he engage in high liability enterprises, i.e. land developer, builder, property pyramider, etc?
Questions like these will help you decide if he is the kind of person you want to trust with your money, since that is what you are doing. Remember, even though you gave your money to someone else for the note, the payor is indebted to you.
But do you know who is legally allowed access to credit records? Are there restrictions on what the information in a credit report is to be used for? What are they? Can you check someone’s credit for any reason at all? Do you have to have their written permission? Are there exceptions?
The Fair Credit Reporting Act (P.L. 91-508) is the law that governs these issues and others. Here’s what Sec. 604 says:
“A consumer reporting agency may furnish a consumer report under the following circumstances and no other:
1. In response to the order of a court having jurisdiction to issue such an order.
2. In accordance with the written instructions of the consumer to whom
3. To a person which it has reason to believe —
A. intends to use the information in connection with a credit transaction involving the consumer on whom the information is to be furnished and involving the extension of credit to, or review or collection of an account of, the consumer; or
B. intends to use the information for employment purposes; or
C. intends to use the information in connection with the underwriting of insurance involving the consumer; or
D. intends to use the information in connection with a determination of the consumer’s eligibility for a license or other benefit granted by a governmental instrumentality required by law to consider an applicant’s financial responsibility or status; or
E. otherwise has a legitimate business need for the information in connection with a business transaction involving the consumer.”
The federal Fair Credit Reporting Act (“FCRA”) was amended by the Consumer Credit Reporting Reform Act of 1996. Section 604 (a) (3) (E) has been added to “Permissible Purposes of Reports.” It states that a permissible purpose is given to a person who “intends to use the information, as a potential investor or servicer, or current insurer, in connection with a valuation of, or an assessment of the credit or prepayment risks associated with, an existing credit obligation…”
Therefore, this section gives a permissible purpose for potential investors, servicers or insurers of credit obligations to obtain a report on a payor for the purpose of evaluating or assessing the credit or prepayment risks involved in existing credit obligations of the payor.
For example, an entity which plans to buy a note and trust deed would have a permissible purpose under this section to obtain a consumer report on the payor for that particular transaction.
For the text of the law, see www.wdia.com/fcra604.htm
Lorelei Stevens, president of Wall Street Brokers (206-448-1160, www.wallstreetbrokers.com) has been spearheading the credit issue on behalf of the note industry for years – unofficially, of course, since there is no organized “note industry.” (Reminds me of Will Rogers’ comment, “I’m not a member of any organized political party. I’m a Democrat.”) She’s corresponded with credit bureaus, state regulators, hired attorneys and has engaged in a continuing dialogue with the Federal Trade Commission over the legalities.
Lorelei obtained the Associated Credit Bureau’s analysis of the changes to the law. It says:
“Section 604(a)(3)(E) creates a permissible purpose for potential investors, servicers or insurers of credit obligations to obtain consumer reports for the purpose of evaluating or assessing the credit or prepayment risks involved in existing credit obligations of consumers. For example, an entity that plans to invest in a mortgage loan transaction would have a permissible purpose under this section to obtain a consumer report on the borrower in that transaction.”
Legally you don’t have to have a signed authorization from someone to check their credit if your need for the information falls under one of the above criteria. However, take the prudent course: even if you don’t think you legally need it, secure their written authorization whenever possible.
Of course, your investment-to-value ratio is more important than the credit of the payors. If there is a large equity in the property and the payors put down a large amount of cash you may wish to proceed with buying the note despite a poor credit history. Be forewarned, however, that someone with bad credit is more likely to declare bankruptcy (see “The Worst Thing That Can Happen” section in this manual).
The Cheapest Insurance You Can Get
Unless you are very experienced in buying notes, the best way to reduce your risk is by having an attorney who specializes in mortgages and real estate involved in the note transaction from the outset. the best attoney for this is one who buys notes for his or her own portfolio, if you can find such a rarity.
Why should you spend money on a lawyer when you’re buying a mortgage?
You shouldn’t. Unless you want to avoid situations such as:
* The note seller doesn’t own the note.
* This is the fifth time this week the note’s been sold.
* The note isn’t properly recorded as a lien against the property.
* What you think is a first mortgage or trust deed is actually a second (or third, fourth or tenth).
* There is an IRS lien against the property (which is superior to even a first mortgage in the chain of title).
* There are judgments, mechanics liens, property taxes owed, private and/or public assessments clouding the title.
* There are easements and/or deed covenants which may limit the use of the property and thus the value.
* There are easements and/or deed covenants which may grant rights to others who are not owners.
* Truth in Lending laws were violated when the note was created.
* The payor has declared bankruptcy.
* The loan documents look fine but violate some law you know nothing about.
If you invest in mortgages without an attorney’s advice, especially when you’re a novice, you’re just asking for trouble. Case in point: if a Virginia trust deed is secured by an owner-occupied property, the due-on-sale clause must be printed in capital letters in the note. It can be worded exactly correctly, but if it’s not in capitals, it’s not enforceable. A good attorney will alert you to pitfalls like this that could cost you thousands or even tens of thousands of dollars if you missed it.
The survey will disclose any violations or encroachments within the boundary lines of the property. The survey should be compared to the facts revealed in the land records.
Finally, mortgagee title insurance should be placed in your name as the note buyer (if it already exists there should be no additional cost) to protect you from any long-buried problems that were not revealed by the title search, such as forged signatures, single people who were actually married but no spouse signed the deed, undiscovered liens against the property, Truth in Lending violations in a prior sale, “off-record” occurrences, judicial enforcement of covenants, conditions and restrictions [“CC&R’s”], etc.
I’ve heard it many times before: “But here (in California, Nevada, etc.) we don’t use lawyers for real estate escrows, we use title companies.” No, you use lawyers, too. The difference is, you pay them and they work for somebody else (the title company). When we pay a lawyer, he works for us.
(Please don’t quote the lawyer’s “fiduciary responsibility to both parties.” I maintain that’s a fiction. A lawyer cannot represent both sides in a potentially adversarial transaction, as this is. Besides, there are three parties: the seller, the buyer and the title company, who retains the lawyer and is thus his client).
When you hire a lawyer, his sole concern is to protect you: not so for a title company. There’s nothing inherently wrong with using a title company to process the paperwork, but have your own attorney review everything beforehand.
A good attorney familiar with the real estate laws of the jurisdiction in which the property is located is the cheapest insurance you can get. Just as having a doctor who prevents health problems is better than getting sick, having a lawyer who prevents legal problems is better than getting sued!
Few attorneys are paper specialists. If you don’t know of one, ask other investors who they use. Ask the same of mortgage companies, paper and real estate brokers and apartment associations in your area. See what names are mentioned most often. Call and ask what their fees are to do what you need. Visit them and pick the one you’re most comfortable with.
Here’s a secret not known to many: one of the best ways to get a top attorney is to call the local real estate board and ask who their lawyer is.
It should make no difference what “they” do transactions in your area. When your money is at risk, get representation.
Check The Documentation
Even with an attorney, it is vital that you get, read and understand all the documents relative to the transaction. Never sign something until you know what it says. You’d be surprised how many people violate this rule every day.
If you don’t understand something in the documents, ask your lawyer; if he doesn’t understand it, don’t buy the note; if he wrote it and doesn’t understand it, find another lawyer!
Are the note and security instruments in proper legal form? Are all the requirements for a note and mortgage or deed of trust in the documents?
Some of the recommended clauses that often are missing from note documentation:
* Statement of the method and type of advertising for a foreclosure to allow a minimum time period;
* The right, but not the requirement, to make advancements to pay superior liens and have all such advancements automatically added to principal and draw interest;
* If interest is unpaid for a month, it should get added to principal and then draw interest (if permitted by state law;
* If payments are not made, a higher default interest rate should come into effect (within legal limits).
If you are going to be a successful investor in a substantial number of notes, you should become very familiar with note legal terminology. Larger book stores carry (or can order) books that are glossaries of real estate legal terms. This is an excellent way of familiarizing yourself with the subject.
Look at the face interest rate of the note. Most states enforce usury laws: know what those are and make sure the note doesn’t exceed it. You can get into major trouble if you own a note that violates the usury law. Points and fees that effectively boost the interest rate beyond the usury ceiling may not be legal.
For a useful summary of state usury laws, consult the last volume of the current edition of the Martindale-Hubble Law Directory. You can find it in a law library or in many attorneys’ offices.
Buying a note at a discount that gives you a yield above the usury ceiling may or may not be a violation of the law, depending upon the state. Different states have different laws. For example, Florida requires three parties to a discounted mortgage transaction (the mortgagor (payor), the note seller and the buyer). Virginia restricts certain loans to business purposes only. States have many laws that define usury based upon the property and the purpose of a loan. There may be one usury law for loans against mobile homes, another for home mortgages, etc. In the state in which you are doing business a loan made for business purposes may be exempt from usury altogether. Check the state laws through an attorney before you act!
Find out who holds the first lien; if it’s not a commercial institution, why not? That could mean the property and/or the borrower couldn’t qualify. It also is likely the first lien documents are non-standard and possibly faulty. That would put your whole position in jeopardy.
Also, an individual first lien holder may see default as an opportunity to profit and insist on you cashing him out. In short, there are plenty of good seconds available that are behind commercial firsts. Be extremely cautious about seconds behind private first liens.
You reduce your risk if the first lien is at a low fixed rate; that makes it easier for the mortgagor to pay you on your second note.
Similarly, be wary of second position notes behind firsts with “creative” financing: big balloons, adjustable rates with no or high caps, negative amortization, shared equity, blanket encumbrances, subordination clauses, substitution of collateral, etc. Again, you’re most likely to find such contorted financing in private loans.
You can reduce your risk in such cases by purchasing just part of the second, but unless you’re an expert, well-experienced note investor, avoid such notes entirely.
The safest route is to only buy notes in the first lien position. I rarely consider seconds for my own portfolio, for several reasons. Purchasing a first is a simpler and cleaner transaction (you don’t have to review any senior liens, you don’t have to notify senior lienholders, etc.). You don’t have to check every month with senior lienholders to see if they have been paid. You don’t have to worry that a senior lienholder is foreclosing (which could wipe you out). You are in the most powerful position possible in case of default.
If you want to buy seconds, realize that first liens may be subject to call in the event of foreclosure. In some areas, custom, not law, governs this. Since “custom” comes down to whatever the lenders feel like doing today, I prefer to hang my hat on the law.
Whenever you. buy a second position note, send the first lien mortgagee a letter informing them that you hold the second lien and would like notification in the event a payment is late on the first lien (for a sample letter, see the THE PAPER SOURCE’S OWN CONTRACTS, WORKSHEETS, CHECKLISTS, FORMS AND SAMPLE LETTERS VOLUME I
FHA loans may not be assumable. It depends upon when they were created. It is therefore vital that you determine when the loan was originated and check with your lawyer on the assumability of that loan under the foreclosure laws of your particular state.
Another little-known trick is to run an amortization schedule on the first lien (even when you’re buying the second) and compare the current balance on the paperwork to what your schedule shows. Any differences may mean there have been late or missed payments (you received the computer software to do this as part of your PAPER SOURCE JOURNAL subscription).
Make sure there is an “acceleration clause” in the first and second lien documents requiring the immediate payment of the balance due in case the property is sold, the payor fails to make his payment, or fails to pay the taxes or insurance. The best acceleration clause gives the note holder the option to accelerate the balance due, since, if the property is sold, you will then be able to decide if you want your money or perhaps want to restructure the note, charge an assumption fee or play banker in some other way.
If you’re buying a first position note, it’s additional protection for you if it is in front of a solid second mortgage (or trust deed). In case of default, the second lienholder must keep the payments coming to you or risk losing his security.
Ditto if you’re buying a second in front of a third position note, especially if the third is held by the person who sold the property. If the mortgagor defaults, lienholders behind you must take over payments to you or risk being wiped out in foreclosure.
Before you buy the first lien, thoroughly investigate the financial stability of the second lienholder. Now, given the preceding paragraphs, why should you care about the financial situation of the second lienholder? Again, a little-known fact: The junior lienholder can declare bankruptcy and shelter his assets from foreclosure, and guess what: one of his assets is the property in which you both have an interest!
I haven’t discussed investing in third lien notes. That’s because most investors shouldn’t buy them. There’s a reason the yields are higher, and the reason is increased risk. Stay in the second or preferably first position.
In 1990, the New Jersey Superior Court (The Howard Savings Bank v. Brunson) created yet another risk factor. It ruled that a mortgage that is placed in the record book but not properly indexed (filed for reference) is not legally recorded.
That means that, at least in New Jersey, don’t assume that a mortgage is recorded by relying on a copy of the mortgage showing the clerk’s stamp with the deed book and page number. The safest route, whether in New Jersey or anywhere else, is to do a title search on every note you buy. And if you originate mortgages, you must make it a practice to order a title bring down after you have sent the mortgage for recordation to insure that it has been indexed properly.
The Most Ignored Risk Factor Of All
If there is one risk factor more ignored by note investors than truth-in-lending requirements, I don’t know what it is. Congress passed the Truth in Lending Act in response to shady lenders who were deceiving borrowers by hiding the true costs of their loans. Now all lenders are required to disclose to borrowers the amount and terms of a loan, including the total cost over the life of the loan, where the borrower is a homeowner borrowing on his house for non-business reasons. There is a standard disclosure form that is completed by the lender, signed by the borrower to prove he received it and filed as part of the loan documents.
This has a tremendous impact upon the way mortgage and trust deed investors do business. Unfortunately, most of them don’t know it, and may not know it until their notes are declared null and void by the court.
When you are considering a note, you must discover the circumstances under which the note was created. If the mortgagee, such as a property seller, is a lender covered by the law and the note is subject to the law but there is no truth-in-lending disclosure statement among the loan documents, and if the mortgagor is an owner-occupant, the note violates the Truth-in-Lending Act and may be unenforceable.
It’s not hard to be legally classified as a lender. All the property seller has to do is make a couple of loans a year. If you are ignorant of the truth-in-lending law, or fail to investigate the origins of a note, you may well find yourself owning an uncollectable, worthless obligation.
Loans for business purposes are often exempt from the Truth in Lending Act, but this is a tricky area full of pitfalls.
Servicing Your Notes
Most investors prefer to keep total control over their note collections and bookkeeping, and that’s what I recommend. However, some leave these tasks to a competent professional. There are escrow companies you can hire for a nominal fee to service your notes.
A good escrow company will track principal and interest payments, send late notices, accept and disburse payments, hold documents in escrow, provide annual IRS reports to you of interest earned and paid, escrow and disburse taxes and insurance and serve as an impartial third party focal point for privacy or other reasons.
Even if you’re buying the note from a broker, don’t let him service the note. Either service it yourself, or hire a third party.
Once you own several notes it becomes a chore to service them and you should consider computerizing that task. NoteSmith is the best note servicing software available for note investors and brokers. Call 800-526-5588 or visit www.notesmith.com for information.
Buying Notes From Note Brokers
Some people prefer to deal only with private sellers, believing they can negotiate better deals with them than they could with note brokers. Some people prefer to invest through brokers, since a good one will take care of all the details.
There are brokers, and there are brokers. Some brokers unknowingly sell unenforceable notes (see the previous section on Truth-In-Lending). Licensing doesn’t guarantee competence. In fact, government licensure functions simply to restrict competition (licensure), but that’s another book. Ask the broker these questions:
* How long has your firm been in business?
* Is the firm insured? Bonded?
* How many employees do you have?
* Is your firm a member of a state or national mortgage broker’s association?
* Who appraises the properties?
* Are your appraisers certified? By what agency?
* Are the appraisals reviewed by a senior appraiser?
* Do you offer recourse (guarantee the notes)? If not, why not?
* Can you give me the names, addresses and phone
numbers of your bank, a creditor and two of your clients?
* Do you have direct control, either via ownership or a contract with the owner, of the notes you advertise for sale?
* What do you do to check out the safety, soundness and legality of the notes you broker?
Check with the county in which the broker is headquartered. Most have consumer protection agencies that at the least can tell you how many, if any, complaints have been filed against him. Also call the local office of the Better Business Bureau.
The safest approach is to confirm everything the broker says by hiring your own lawyer, appraiser and credit agency: it’s more expensive, but it’s cheap insurance.
If the broker seems anxious, if you are under pressure or are made to feel any obligation to go through with a transaction, just walk away. There are plenty of ethical brokers with good notes out there. A list of them is THE PAPER SOURCE REGISTRY OF NOTE INVESTORS.
A Word On “Hard Money Loans”
Sooner or later you’ll discover the first cousin to the discounted note, called a “hard money” note. These are popular investments in California.
A hard money loan, also known as an equity loan, is nothing more than a note that is created when a homeowner borrows against his equity. The classic hard money borrower is either in a hurry and cannot wait for conventional sources or he cannot get a loan through such sources. He may have bad credit, may be unemployed or earn very little, may be a senior citizen on a small fixed income, may have a ton of consumer debt that he’s behind on, may have declared bankruptcy in recent years and/or may even be in foreclosure. The only asset he has is the equity in his house, so he sees an ad and goes to a hard money lender to borrow against his home.
The hard money lender is primarily or solely interested in the home’s equity and has less concern about the financials on the borrower. He charges high interest rates (sometimes the highest the law allows), points and other fees, usually writes the note for a few years interest-only with a balloon, includes a pre-payment penalty, and sells the note for the face balance (called “selling at par”) to an investor. The investor’s yield is the interest rate at which the note is written.
Hard money loans can be good investments, but you have to be very careful. The integrity of the broker is key. The note is not discounted, so an early pay-off won’t increase your yield (excepting the effect of the pre-payment penalty). That’s not a big deal because these loans are rarely paid off early. The reasons are: 1) the pre-payment penalty discourages it and 2) the borrower usually has no prospects of getting any money.
The real danger of hard money loans is when the borrower defaults on the note and takes the lender to court. The court can rule that the lender, (even though he followed all the rules) took unconscionable advantage of the borrower, wipe out the debt (your note) and punish the lender.
Get Title Insurance
Some people confuse title insurance with fire or hazard insurance, which it is not. Title insurance is a specialized type of insurance that protects an investment in real estate. Also, some think that when you buy a house the title insurance you buy covers you — that’s not true either unless you pay even more for owner’s coverage. What you’re buying initially is lender’s coverage. I’ve always thought lenders pull a pretty neat trick by getting somebody else to buy their insurance.
Lender’s title insurance is only for the amount of the loan. The equity in the property is not covered. In addition, the lender’s policy expires when the loan is paid off.
When you buy a note, you want a mortgagee’s title insurance policy, which protects against loss due to any defects in the title, and loss due to liens and/or encumbrances upon the property at the date of the policy.
Always make sure to get mortgagee’s title insurance to protect your investment in the note from any title problems, such as a forged deed, a mistake in the documents, errors in the title search, unrecorded liens, or hundreds of other potential problems.
Additional protection is available, at a cost, to protect you from a myriad of possible difficulties that may not be covered by basic title insurance — from insuring a modification of the mortgage, to securing future advances, to protection against mechanics liens filed after the transaction was completed (on the theory that the contractor’s work was completed before the transaction), to just about anything you can think of.
“Endorsements – Their Uses and Availability” is a very useful booklet describing many of the available additions to a standard title insurance policy that expand coverage to fulfill specific requirements you may have. It’s available at no charge from First American Title Insurance Co., 714-558-3211.
With larger notes, you can also insist, as do institutional lenders, that the title company issue you an “insured closing letter,” insuring you against the malfeasance of the closing agent. If the funds are not disbursed properly, the title company will cover it. Anyone wiring funds to buy mortgages or real estate should always have an insured closing letter in hand, backed by a national title company, before any monies are transferred.
In many states, if a title policy was issued when the note was created it remains in force when the note is sold. Be sure to order a “title bring-down,” or update, to determine if any liens have attached to the property since the policy was issued. Liens junior to yours won’t affect your equity in the note, but it tells you something about the mortgagor if he has a bunch of liens on his property.
In other states you will have to purchase a new policy when you buy the note. It doesn’t cost much, and won’t cost you anything if you’re buying a purchase money note created at settlement, because you are simply added to the insurance as a loss payee.
Don’t underestimate the importance of title insurance. The likelihood of a loss due to a defect in the title is statistically very slight, but if there is a defect it could be very costly without title insurance. For example, a PAPER SOURCE subscriber once bought a second lien note that turned out to be a third lien. Because he had title insurance, the company paid him the full face amount for the note he had bought at a deep discount.
You wouldn’t buy a house and fail to insure it against fire and other hazards, would you? Then don’t buy a note secured by a house and fail to be insured against the same losses.
All you need to do after you become the owner of a note is to write a letter to the insurance company (or better, have the note seller do it) informing them that you are now the mortgagor and asking them to place you on the policy as an additional loss payee. It costs nothing and may pay huge dividends some day.
Recording Your Interest
Once you’ve bought the note, recording your interest at the county courthouse where the property is located puts your position on the public record. If the person who sold you the paper turns out to be a crook and tries to sell the same note to multiple parties, or tries to create other encumbrances on the property, this will help to protect you.
Who Pays For All Of This?
When you’re buying a note, you should pay all the fees. When you’re selling a note, you should pay all the fees. That’s no misprint. The only way you can keep total control of the situation is to have all third parties working for and reporting to you.
Factor those costs into what you’re willing to pay for a note, and quote a price that is net to the seller. It’s a selling point if you can advertise, as I do, that “I never charge extra for points, fees, commission or any other “hidden costs.” My quote is the exact amount you will receive.”
Your contract to purchase the note should specify that the note seller will pay all the fees up-front, and that the attorney will reimburse him for these costs immediately after the note has been transferred and recorded (you, of course, reimburse the attorney). That way, if the transaction falls apart after costs have been incurred, you don’t end up paying bills for a note you never bought.
We live in a sinful world. Dishonest note sellers exist. Take the Lord’s advice and be “wise as a serpent and harmless as a dove” (Matt. 10:16). Pay attention to your initial impression of the seller. Avoid those exhibiting pressure tactics or who seem anxious.
Get written documentation for every assertion the seller makes — remember, he’s the one trying to impress you. Do the math on every figure he gives you. When you get the documents, compare the signatures. Discrepancies could mean forgeries.
As evidence of the seller’s ownership of the note, he should provide you with a copy of his title policy insuring his interest in the note (if he has it), a copy of the recorded assignment with the clerk’s stamp showing where and when it was recorded and a copy of the back of the note showing assignment to him (if he was not the original mortgagee) or a copy of the recorded assignment form.
On Selling Notes To Private Investors
I’m often asked about selling paper to private investors. Unless the inquirer is a very experienced note buyer, I answer in one word: don’t. It’s not just that individual investors are often unreliable, although that’s a major annoyance. The biggest drawback is that if you sell notes to private parties or, worse, take them in as partners, you are opening your door to government regulators, IRS auditors, process servers, and all sorts of people you’d just as soon not meet.
Before we proceed, let’s define “private investor.” By it I mean someone who is relatively ignorant of paper and who isn’t interested in learning. A private investor simply wants to increase the yield on his money. The people who would respond to an ad in the paper promoting double-digit yields would all be private investors (and the ad might be illegal – more on that later).
Many people ask me why I recommend that you sell notes only to professional note buyers and not to private investors. There are at least 4 reasons for this:
1. As long as the note is exactly what you’ve said it is and the documentation is in order, a professional’s bid is a commitment to buy. This is not the case with a private individual. He may run out of money, find a better deal or change his mind for whatever reason, and you will have wasted your time, effort and possibly money for nothing.
2. If you sell a note to a private investor and it goes bad, the investor may want you to make it good. A professional note buyer will not.
3. The law presumes the professional knows more than you do about paper. In the very remote chance that a dispute occurs, this presumption would work in your favor. However, the presumption might be reversed if you sell to investors, and you as one who has been trained in paper would be presumed to know more than a private individual.
4. If you sell notes to private investors without a state or federal securities registration you may be in violation of securities laws. The vast majority of paper investors – even those who’ve been in the business for years – have never heard anything about securities laws. I know. They tell me so constantly. Most of the others have heard something about it but don’t know if it applies to them or not.
Let me set the record straight, once and for all, so you don’t run afoul of the law. There are both federal and state securities laws. Federal securities laws regulate transactions that cross state lines. For example, the property secured by a note is in one state and the investor to whom you sell the note is in another state. Or, you and the property are in the same state and the investor is in another state. If the investor and the property are in the same state and you as the broker are in another state federal securities laws could still apply.
Remember, though, that even if you know and follow the federal laws, and your advertising, collateral, buyers and sellers all come from within your state, you could still violate laws of that state. In fact, state regulators are more likely than federal ones to go after you simply because they don’t have 50 states to monitor.
There are four criteria that determine whether you are selling notes or securities. If you do all four there’s little question that the law will define your sale as a securities transaction. If you do just one, that may not happen, but any time you trigger even one criteria you are putting yourself at risk:
It Coould Be A Security, Not A Note, If…
1. You sell a note to a private individual as opposed to a licensed mortgage broker, bank or some other financial institution.
2. You sell parts of notes as opposed to whole notes. You compound this mistake by selling parts of notes to multiple investors .
3. You guarantee the investment. For example, if you promise to buy back the note from the investor or replace it with another if it defaults.
4. You service the note. That is, if you collect the payments on the note and send payments to the investor and/or send late notices, escrow taxes and insurance, handle defaults, etc.
YOU DO NOT HAVE TO CROSS STATE LINES OR TRIGGER ALL FOUR TO HAVE YOUR NOTE SALE BE DEEMED A SECURITIES TRANSACTION. How many qualify? No one can say with authority, since it is somewhat up to the discretion of securities regulators.
You would ring all the bells if you sold part of a mortgage secured by property in your state to a private individual living in another state and you serviced the note and guaranteed his investment in case of default. In this case the law says you didn’t sell a mortgage, you sold a security. Unless you are licensed to sell securities and what you’re selling is registered as a security you are in major trouble.
The bottom line is, you can’t cross state lines to sell what the law defines as securities without having state and federal registrations. If you’re a note investor and you give your money to someone else and they do all the work and all you do is cash the checks, you’ve bought a security, even if no state lines were crossed.
Should you never sell a note across state lines? Should you never guarantee a note? Or service a note? No, that’s not what I mean. You can do any of these, but be careful of combining them.
If you’re selling to a party in another state, sell the whole note, lock, stock and barrel, with no guarantees and no servicing. You can sell a note, even to a private individual, across state lines (as long as you don’t violate the laws of either state), but don’t sell a partial, don’t service it and don’t guarantee it. You can sell a partial, service it and guarantee it, but don’t cross state lines. If you’re considering this, do yourself a favor and have a lawyer who knows securities laws watch over your shoulder.
Your safest approach is to sell notes only to professional buyers and never service or guarantee them (which a pro would never expect or want you to do anyway).
If you sell partials, even within your own state, never, ever sell to more than one other party. Don’t split up a note into two, three or more investors. That’s just asking for trouble, even if they’re all in-state. The owners of partials should be strictly limited to two: you and one other party. Beginners often discover they can make even more money by splitting a note into a bunch of parts and selling each part to a different investor. This is a serious mistake. Don’t you make it.
I teach a course on how to sell notes to private investors. It is quite advanced and we study the laws and many court cases. The idea is for you to be able to leave the course knowing what to do and what not to do when selling notes to private investors. I usually teach it once a year, sometimes not that often. E-mail me at firstname.lastname@example.org or call 830-895-5025 if you are interested in it.
Advertising and mailings to buy notes aimed at prospective note sellers across state lines is not a violation of federal securities law, but a few states prohibit out-of-state solicitations by parties unless they are registered in those states.
However, if your solicitation seeks investors, the laws are more restrictive. In addition to state and federal laws, you must comply with federal postal regulations governing the content of such solicitations.
Even if you hold the proper registrations, you can be charged with fraud and/or misrepresentation if you fail to abide by the laws governing the content of advertising and solicitations. A huge mistake is to guarantee yields. Regulators scan publications looking for such ads as “15% Return Guaranteed.” It’s best not to solicit for investors.
Unless you are an experienced note broker and have been trained to work with private investors you should avoid all of these potential problems by dealing exclusively with professional institutional note investors.
The Worst Thing That Can Happen
If your note payor declares bankruptcy, you are in trouble. The subject of bankruptcy and the paper investor would make a book in itself (see the section on bankruptcy in George Coats’ book “Smart Trust Deed Investment (in California).” If you don’t have the book, get it right away. It’s indispensable whether or not you live in California. Call 1-800-542-2270 to order it).
The best way to deal with bankruptcy is never to be caught by a defaulting payor. Guard yourself by learning to predict candidates for bankruptcy. Review the questions you should ask about a credit report with the possibility of bankruptcy in mind.
If your payor is in default, do not hesitate to begin foreclosure. Depending upon where you live and the type of property, if you initiate the foreclosure process before he files for bankruptcy you may be able to continue foreclosure.
Since this is a complex area and because the laws differ in each state, it is vital that you consult an attorney who is well-versed in bankruptcy and the rights of lienholders. If you don’t know of one, call David Nielsen at 1-800-635-6128. He runs the U.S. Foreclosure Network, a national referral service of attorneys specializing in the subject. Be sure to tell him you’re a PAPER SOURCE subscriber.
Some people are “professional bankrupts” with a history of running up obligations and then declaring bankruptcy. Even the legal limit of one bankruptcy every seven years doesn’t stop them. They just sell part interest in their property to someone else who goes bankrupt, tying up the property. Or, they do business corporately, exempting them from the 7-year rule. Even the 7-year rule does not stop them from FILING for bankruptcy (although they won’t be successful), and it is the filing that prevents you from taking action.
The best advice is to do everything in your power to avoid the situation before it happens. Once you’re involved, what options you have are time-consuming and costly. If it looks like your mortgagor is about to declare bankruptcy – if he ever even mentions the word – get competent legal counsel at once.
I hope I haven’t scared you away from paper by warning you of the pitfalls; that wasn’t my intention. If I have tempered your enthusiasm with sound advice that has kept you from losing money — or worse — then I’ve accomplished my goal.
Naturally, in paper, as in any investment, risk will always be a key factor. Applying the field-tested methods of risk management as outlined in this manual will help you to drive down the risk and work toward making your portfolio as risk-proof as possible.
My hope for you is that if you make a mistake, let it be because you didn’t buy a good note: not because you bought a bad one.
Copyright 1999, The Paper Source, Inc. All Rights Reserved.
W. J. Mencarow, Jr. has been investing in notes since 1981. He is the editor of THE PAPER SOURCE newsletter, the first and largest national publication exclusively devoted to notes. He is also president of The Paper Source, Inc., which he co-founded with his business partner and wife, Alison, in 1987. In addition to countless articles in his newsletter and others, he is the author of How To Get Started In Notes Without Using Your Own Funds and Almost Everything That Could Go Wrong With A Note (and How to Prevent It!),
and several courses. In 1997 he received the Note Industry’s Founder’s Award for founding the first nationwide note publication and national convention, and was inducted into both the Mortgage Report Hall of Fame and Metropolitan Mortgage’s Note Industry Hall of Fame.
He previously served for a decade with the U.S. House of Representatives in Washington, D.C. He was Minority Counsel and Staff Director of a subcommittee a congressional press secretary and legislative director, where he had the responsibility of drafting and shepherding many bills through Congress. He and Alison met on Capitol Hill, where they were both Congressional press secretaries.
Before coming to Washington, D.C. in 1978 he managed a dozen political campaigns, was a Field Director for Ronald Reagan’s presidential campaign, served as the coordinator for all Reagan volunteers at the Republican National Convention, and served as an advisor to the Presidential Transition Committee. In addition, he was a television and radio talk show host for eight years in the Chicago area and producer of the number two morning radio progam in Chicago.
During his political career he appeared on many radio and TV programs including Good Morning America and was interviewed on many networks and major newspapers. He has debated Jane Fonda, Gore Vidal, Paul Ehrlich, a dumptruck load of left-wing lawyers, socialist college professors and numerous other slugs. He believes his highest political honor came when a speech he wrote was attacked by Pravda, the official newspaper of the Communist Party of the Soviet Union.
He is ordained in the Presbyterian Church (OPC) as a Ruling Elder and is currently studying for a Masters in Reformed Theology. He and Alison give glory to the Lord for The Paper Source and all He has done in their lives.
Contact him at notes@PaperSourceOnline
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