Balloon notes have always presented a special problem for Note Buyers. Why? Because the yield of a Note Buyer is dependent on the note being refinanced or paid off on or before the due date. This is a very dangerous assumption. I will remind you of the cardinal rule in all investments, especially note buying: YIELD IS NOT REALIZED UNTIL YOU ARE PAID OFF!! With this in mind if the payors could not get a conventional loan at the time of sale, what makes anyone think they will be able to refinance at the time of the balloon?

Let's take an example of a note with a $100,000 balance @ 5% interest, paying $659.96 monthly amortized over 240 months, and a balloon payment of $83,455 due in 5 years. Assume the Note Buyer wants to achieve a 12% yield. Remember that a balloon note actually has two cash flows; the monthly payments and the balloon payments. With this in mind, let's examine different ways of purchasing balloons.

If the Note Buyer is aggressive and desires to purchase the entire note, he/she would pay $75,606

N = 60
I/Yd = 12
PV -$75,606
PMT = $659.96
FV = $83,455

The issue with this method of purchasing a balloon is the high risk the payor will not able to refinance on or before the due date. If the note is not paid off on or before the due date, the Note Buyer must either foreclose or extend the note. If taking the property in foreclosure is the business model you choose for purchasing notes, then this aggressive method might prove beneficial. However, if your main purpose in investing in notes is the outstanding yields and cash flow, this method will fall short of expectations.

Why? Because if the note has to be modified or extended to avoid foreclosure, the yield will drop immensely due to the fact the yield was based on a lump sum payment in 5 years. For this reason, most Note Buyers do not feel comfortable with a full purchase offer on short fuse balloons.

If you are selling a note with a short fuse balloon, do not be surprised if you do not get a full purchase offer or the offer is less than you expected. If the Note Buyer feels uncomfortable the payor will be able to refinance in 60 months he/she will be more cautious in the purchase.

Purchasing only the payments, while letting the note seller keep the balloon is one method to reduce the risk the payor will not be able to refinance in 5 years, while at the same time maintaining a 12% yield.

N = 60
I/Yd = 12
PV = -$29,668
PMT = $659.96
FV = 0

When I use this method, I actually would purchase only 58 months of payments. This will allow for a two month cushion until the balloon is due. This just gives me a little more security, because if the payors think they are going into default, traditionally they will quit making payments a couple of months out before the due date. This method gives an additional advantage to the Note Buyer, as well as the note seller and the payor because it will give all involved a cushion to modify the note to avoid foreclosure, and at the same time give the opportunity for more payments to be sold.

Would I purchase future payments on this modified note? If payments were timely and nothing else had changed, of course I would purchase more payments.

Another method of purchasing a balloon note is to assume the payor will not be able to refinance to pay off the note. To compensate, the Note Buyer will treat the note to be self liquidating. "Self liquidating" means assuming the note to be a straight amortized loan, in this case 240 months. If in 5 years, if the note cannot be paid off, the note can be modified with the same terms and payments, and the Note Buyer will maintain his/her yield. The purchase will look like this:

N = 240
I/Yd = 12
PV = -$59.937
PMT = $659.96
FV = 0

Still another method to help assure the Note Buyer will maintain his/her yield, is by assuming the note will have to be modified at the time of the balloon, but rather than modifying the note as self liquidating, the Note Buyer will purchase the note with an assumption the balloon date to be extended to say 120 months instead of 60. If the Note Buyer has to extend the balloon another five years, his/her yield will not be damaged. The assumption is that in 10 years the property will be sold or paid off. A ten year balloon has much less risk that a 5 year or 3 year balloon. The purchase looks like this:

N = 120
I/Yd = 12
PV = -$64,852
PMT = $659.96
FV = $62,221

Notice the difference in the purchase price of these four methods. Quite a difference, isn't it? How does a Note Buyer determine which method to use? This is a subjective evaluation which depends how the Note Buyer weighs the risk based on the credit score of the payors, the seasoning of the note, the property's valuation, and last but not least, the goal of the Note Buyer.

There is still another way to purchase a balloon note; purchasing the payments and part of the balloon. This method is becoming more and more popular among many Note Buyers. Because of the complexities these methods cannot be discussed in a newsletter forum.

I will be covering this material on August 23rd at my Advanced Notes and Real Estate Techniques Workshop. If you want to keep up with current note trends, be sure to attend. SIGN UP NOW

Conclusion: We addressed four methods of purchasing balloons. Each has its strengths and weaknesses. As a professional, it is your responsibility to be aware of these different methods whether you are buying a balloon or selling a balloon.

CAUTION: WITH THE DODD FRANK LAW BEING IN PLACE THAT AFFECTS BALLOONS, I STRONGLY SUGGEST YOU SEEK EXPERT LEGAL ADVICE.

CONTACT ME if you have questions or comments. And remember, if you know of someone who has a note to sell, I DO PAY REFERRALS.

Copyright © H&P Capital Investments LLC
All rights reserved
Tom Henderson
a.k.a. THE NOTE PROFESSOR

Real Estate
Note Newsletter and Archives
Click here to subscribe or view the archives of past information packed issues 2003 to 2009. (Current archives 2009 though May 2014 click below.)
Forward this newsletter to a friend that would have an interest in Owner Financing and Real Estate NOTES.

Click here for Current ARCHIVES (end of 2009 through May 2014)

One of my new readers asked me to comment on why we do not need banking regulations since it was "deregulation" that caused the collapse. This is a common misconception. In this issue I will address two issues to dispel the myth that deregulation caused the financial crisis. First, the banking industry has NEVER been deregulated. This is a ruse to try to convince us we need more bureaucrats to determine how and to whom money will be lent. At best the banking industry has been reregulated; and at worst misregulated. Second, contrary to popular opinion, banking regulations were not only ineffective in preventing the financial crisis, regulations actually contributed in a large part to not only the causes of the financial crisis, but are in no small part the reason we have not recovered.

To begin, realize when there is a breakdown in any economy, there is no one reason for the collapse, but rather a series of events caused by bureaucratic interference into the economy. These interferences set in motion the laws of supply and demand, which results in undesirable consequences, no matter how well intended the regulations. While the financial crisis was triggered by the Federal Reserve's easy money policy, government regulation added gasoline to the fire.

Government regulatory agencies are staffed with political hacks and career bureaucrats. Rather than having the overall interest of the American public, government agencies are often guided by the political atmosphere of the times. In good times, regulators will overlook or turn a blind eye to certain regulations under the false belief "these regulations are not important right now." Selective enforcement is the norm. Such are the cases of Bernie Madoff, Enron, and WorldCom as examples. Red flags were all over these scams, but regulators chose to ignore them because people were making too much money.

Likewise many banks that had very low reserve requirement should have also been raising red flags. However, instead of regulating the banks' low reserves, the feds encouraged the low reserves because the computer models said everything is OK", and banks should continue the low interest, easy money policies. Remember Citigroup, Washington Mutual and Wachovia? Where were the regulators?

To add gas to the fire, banks that saw the bubble coming and increased their reserves in anticipation of future hard times were threatened and penalized by federal agencies for increasing their reserves. Being penalized for applying sound lending practices induced banks and CEOs to "go with the flow" and continue making subprime loans without the necessary reserves to cover these weak loans. This threat of penalization set in motion loans being made that were not sound.

Government regulators are a product of a political industry. When times are good, regulators are almost nonexistent or will turn their heads to the regulations they have on the books. However, when times get bad, the regulators will swarm over an industry like ants over chocolate screaming "We need bureaucrats to regulate banking and all industries".

In the last fiasco, there is no mention the banking system is already regulated by several agencies and laws, including the FDIC, Federal Reserve, SEC, Patriot Act, Privacy Act, Sarbanes Oxley Act, Value to Market and Community Reinvestment Act, just to name a few. Many of these acts are contradictory to each other, but such is life under a system dictated by bureaucrats. There is no acknowledgement that in reality, there were regulations, but the agencies chose to selectively enforce them because politicians from both parties were benefiting. I could go on with several other examples, but the point is the financial industry was NOT deregulated. It was reregulated and misregulated.

How do regulations actually slow down, and even prevent recovery? A brief explanation of regulations are in order. Banking regulations are derived from computer models. "Optimum" scenarios are programmed into their computers where undesired events or consequences are assigned minimum value.

Sound lending judgment by a loan officer has been replaced with a computer model based on a bureaucrat's opinion of how and to whom a bank should extend loans. Where the regulations were rarely enforced during the bubble formation, once the bubble bursts, banks now go under the microscope using arbitrary computer models.

We are told of the mean, evil lending industry's not lending money is the cause of the slow recovery. Understanding how regulations affect lending practices will give us insight.

Let's examine a common scenario. An investor has a portfolio of 5 ARM real estate loans. Four of them are cash flowing, but one is not. However, the investor makes payments using his/her own funds. When the time comes for the loans to be refinanced, because of Value to Market, the properties have been devalued forcing the investor to come up with additional funds to keep his/her portfolio; or worse, because the investor has one property that is not cash flowing, the mathematical model tells the banker the investor is not worthy of being refinanced.

In a market downturn, both scenarios often force the investor to just walk away. As a result, a performing portfolio goes into default, which further enhances a downward spiral of real estate prices. If a banker were able to use his/her judgment, the investor might well receive refinancing without having to come up with a large lump sum of cash since all the notes are performing, they just are not cash flowing. However, under the mathematical model, this is a substandard loan, and if the bank were to refinance, even with the coming up with cash, the bank will be penalized by requiring more reserves.

To add insult to injury, federal law prohibits the lender from telling the investor the reason for the strict refinancing is due to a regulation. As a result, the investor will often come away with hard feeling toward a bank he/she has done business for years, thinking it is the mean, evil banker, not government regulations. I am sure many of you have similar stories to tell. Now you know it is not the bank, it is a bureaucratic computer model that does not allow for any variance.

I could write for days on how the FDIC promotes faulty loans, how Fannie Mae drove the local banks out of the mortgage business or how these web of regulations takes not only monetary resources away from risk management, but also sound lending practices. However, in this issue, I wanted to demonstrate how the banking industry has NEVER been deregulated, how all regulations are selectively enforced based on political motives, and more importantly to demonstrate how regulations are slowing down and even preventing the economy from recovering. Do not believe the banking industry is not regulated. This is bovine scatology.

If you have questions or comments, CONTACT ME Tom Henderson /a.k.a. THE NOTE PROFESSOR .

Copyright © H&P Capital Investments LLC
All rights reserved

If you have not attended a Note Professor "How To Get Rich with Notes" class, be sure and purchase the Note Professor Note Book manual to enhance your knowledge of creative real estate financing and note buying and selling.

"I got your news letter. It was great, purchased your (Notebook) and it was awesome. I used your renter technique and it worked also. I am getting 41% return thanks to your expert advice. I have spent hundreds and not able to do any thing thru other gurus" Gary W. Garland, TX

"It blew me away what a powerful tool notes can be. Lots of great information, worth every penny! Highly recommended."
Jeff C. The Colony/Investor

"Your manual is short and straight to the point, it's rare to buy something today that gives you your money's worth. Thank you" Stephan B. Phoenix, AZ

You will learn at least one new usable concept to increase your profit in buying or selling notes and real estate.
Tom Henderson, author

By popular demand, THE NOTE PROFESSOR NOTEBOOK is now available in easy, downloadable E- book form for a the low, affordable price of $39.95.

Other products are also available, including HOW TO MAKE OBSCENE PROFITS with SMALL MONEY, and GUIDE FOR SECOND LIENS. There is also a FREE download of CHECK LIST FOR OWNER FINANCING.

Simply go to the NOTE BUYERS STORE. I can think of nowhere that you can find such information packed products at such incredibly low prices. We are still working out the bugs, so if you have any problems, be sure to contact me.