For the Greedy Only: For Those Selling Notes BEWARE


From Page 58 of The Note Professor Notebook

I have not seen this technique in a long time, however, it still seems to be around. I received a call from a note seller who was in dire need of $20,000. For simplicity, I am going to use round numbers rather than elongated actual figures. The note seller had a note for $100,000 at 5% interest for 20 years with payments of $659.96. As she described her note, it was immediately evident this was not an A grade note because of the payor's credit score, the down payment, and seasoning, which means the discount would be steep.

She disclosed she had received two offers from a Note Buyer and wanted to know if I could beat these offers.
"What were the offers?", I asked.

She related the full purchase offer of $60,000. (If you are following on a calculator, this is approximately a 12% yield) She, of course, did not like the deep discount, especially when she needed only $20,000. Although the offer had a hefty discount, the offer was not out of the question for a note of such poor quality.

She then disclosed the other offer was a partial offer that she found to be reasonable because there was no discount. No discount is not a unique sales presentation of a partial, so with great anticipation I awaited her answer. I listened in amusement when she related how she was offered $20,000 for the period of time until the note is reduced by $20,000. It does appear there is no discount. After all, she would receive $20,000, and the note would revert to her after the note is reduced $20,000, and still have a balance of $80,000. This technique is called The Balance Back. Do you see the sleight of hand?

First let's calculate how long it takes for the note to be reduced by $20,000, or in other words an $80,000 value in FV. Let's look:

N = 70.84 (Let's Say 71)
I/YR = 5
PV = -$100,000
PMT = $659.96
FV = $80,000

Under this partial offer the Note Buyer would receive the payments for 71 months, and then the note would revert to the note seller. Seems fair, right? We shall see. What do you think the yield would be?

N = 71
I/YR= 34.22 A Jesse James Yield
PV = -$20,000 Amount Pd. for Partial
PMT = $659.96
FV = 0

WOW!. Why is the yield so high? Remember, a Note Buyer is purchasing cash flow. Since the majority of these payments consist of interest instead of principal, it takes 71 months to reduce the balance to $80,000.

What if I wanted to enjoy a 12% yield indicated in the original full offer? The difference is instead of offering the Balance Back technique; I offer to give the note seller her $20,000 for the period of time it takes to give me my 12% yield. What is the difference? Sit down; this is going to shock you.

N = 36.28
I/YR = 12
PV = -$20,000
PMT = $659.96
FV = 0

Quit a difference between 36.28 months and 71 months, isn't there? Now you know why I titled my article in The Note Professor Notebook: For the Greedy Only.

If someone offers you this type of partial, BEWARE. I was tempted to ask for the contact information of her Note Buyer to find out if he/she learned this technique from The Note Professor Notebook, and if not, from where. However, since I was competing with him/her for the note, I thought otherwise.

If you are a Note Buyer and plan to use this technique, I suggest you use Schedule C when explaining who gets what in the event of an early payoff or default. Don't know what Schedule A, B, C and D are? Look in past issues.

For a little calculator practice, in the above example, what if you rounded up the number of months to 37. What is your yield? Did you get 13.10%? Did you how a small increase in N affected your yield? I hope so. Know how the variables relate to each other can put a lot of money in your pocket.

If you have questions or comments, be sure to CONTACT ME In the subject line, write ASK the PROFESSOR. I will try to answer your questions in the next Note Professor issue.

Remember, if you know of someone who has a note to sell, I do pay referral fees and this has been very beneficial.

To forward this email to friends or business associates who have an interest in time value of money, click the "Forward this newsletter" on the front page. Tom Henderson /a.k.a. THE NOTE PROFESSOR .

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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.

I finally got a chance to see "The Big Short". In a nutshell, selling short means an investor is betting a certain stock, commodity or investment vehicle will go down in value.

The movie had good representation of the mechanics of selling the housing market short. However, in its zeal to create heroes and villains, the movie left out the true villains that triggered the housing market crash in the first place; namely the Federal Reserve (the FED), Fannie Mae and Congress.

The 2008 meltdown was a result of the action and inaction of these three entities. It should be noted that complete meltdowns are usually not the result of one "culprit", but a combination of events and circumstances triggered by political and government involvement in an industry or the economy.

When the FED distorts markets with artificial interest rates for years, while government sponsored entities condone and promote these distortions, and to add fuel to the fire, Congress creates laws and regulations that further enhance these distortions, the end result is an economic meltdown in one form or another. The financial meltdown in 2008 is no different.

Let's begin with the Federal Reserve. I have explained in several previous articles how the FED creates boom/bust cycles by artificially setting interest rates low, thereby distorting market forces. In the financial meltdown example, by keeping the interest rates artificially low, the FED opened the door for real estate mortgage interest rates, especially subprime mortgages, to be so low as invite individuals who otherwise could not afford a mortgage to purchase a home.

In prior issues of THE NOTE PROFESSOR NEWSLETTER, I pointed out that in 2005-2008 interest rates should have been in the 9% range. Along the same lines, many used their homes as an ATM machine by substituting their once high equity homes with a refinance at elevated property values. With teaser interest rates below 4%, it is not a mystery why home purchasers, investors, and home owners would refinance and purchase properties to take advantage of artificially low interest rates?

It should be noted, one function of interest rates in a free market is to adjust to demand for money and to rise and fall accordingly. Since the FED kept interest rates artificially low, while demand for money increased, is it any wonder a bubble formed in real estate?

For example, take a $100,000 mortgage at 4% interest over 30 years. The payments would be $477 monthly. However, if interest rates were at 9%, which they should have been if the FED had not kept interest rates artificially low, the payments would be $805 monthly. Even if lenders accepted "liars loans", the borrowers would not be able to afford the payments. In other words, if interest rates were allowed to reach market level, the real estate market would not have expanded due to artificially low rates, and therefore no bubble, which in turn means NO BUST.

But there were more players that contributed to the meltdown that were not mentioned in the movie, namely Fannie Mae. Fannie Mae is a government sponsored entity that purchases mortgagees in the secondary market. In a nutshell, when a mortgage company or bank originates a mortgage, they would sell them to Fannie Mae. Fannie Mae's, which had become the dominant player in home mortgages because of the elimination of savings and loans. (Yes, the S&Ls demise were government driven) Because of pressure from Congress to buy risky loans, Fannie Mae dove head first into purchasing subprime mortgages from institutions like Countrywide and Washington Mutual. The stage was set for banks to change their business model of originate and hold mortgages to originate and sell to Fannie Mae.

Where local banks once originated mortgages to hold on their books, which meant underwriting was very conservative, banks could now originate as many loans as possible without regard to risk and sell them to Fannie Mae. Likewise Fannie Mae's once conservative approach to purchasing mortgages from banks morphed into purchasing most any loan given them, including negative interest loans.

To compete with Fannie Mae, institutions started originating even more "exotic" mortgages, while at the same time lowering standards, as well as often falsifying documents. The "snow ball" was gaining in both size and momentum.

The movie also indicated that rating agencies, namely Standard & Poors gave these toxic bonds "A" ratings because if they did not, the banks would just go to Moody's. If this is true, then why do banks not put pressure one of the agencies to give "A" ratings on all instruments? The more likely "culprit" is the computer model not only utilized by S&P, but seemed to be the mortgage model used by institutions for years. The collective wisdom was that real estate bubbles were always local. For example, a bubble in California did not affect real estate in Florida or Texas. Because these mortgage portfolios consisted of mortgages from all 50 states, in their analysis the chance of a portfolio going bad nationally was 1 in 1,000.

Normally, this is a valid assumption. However, this assumption does not take into account the national affect of interest rates on mortgages being kept artificially low. "Easy money" bubbles were not built into the programming. Therefore, when the defaults first started to materialize, the ranking agencies, as well as Wall Street ignored the rising defaults as a "glitch" and stood by their bond ratings based on their computer models. Moreover, statistical data on subprime mortgages were nonexistent so no one knew how subprime mortgages would react.

Add to this that in its infinite wisdom, the government decided that only three rating agencies are to be used in evaluating investments: Standard and Poors, Moody and Fitch. Want to add fuel to the fire?

At the beginning, these rating agencies were compensated by the purchasers of bonds and investments. Agencies took great care to properly rate investments in order to protect their clients, the purchasers. The Securities and Exchange Commission changed the compensation arrangement where the bond issuers paid for the rating agencies compensation. Do you see a conflict of interest? Why would the SEC make such an outlandish change? You guess it. Because of political pressure from unions and pension funds that did not want to pay for ratings. In other words, if the rating agencies were pressured to fudge the ratings, blame the SEC for setting up a system that from the onset sets up a conflict of interest.

What was Congress's role in the financial crisis? Let's start with the Community Reinvestment Act (CRA). In essence, this act "encouraged", meaning forced, banks and lending institution to fund neighborhoods and low income borrowers. Without going into the long history of CRA which began in the Carter years, during the Clinton Administration there was pressure to bear for lending institutions to lend to high risk borrowers. Regulators would punish banks for not "meeting the credit needs of low income and distressed neighborhoods". What does "meeting the credit needs of low income and distressed neighborhoods" mean? Like most government policies, it is not defined. Not wanting to be "punished" banks started lending to low credit, high risk applicants. Here is where Fannie Mae comes into the picture and starts purchasing these high risk loans.

Not to be outdone, the Bush Administration picked up, and even enhanced the CRA, with Congress' approval. Bush at one time even boasted his was the "home ownership administration". Of course, when bubbles started forming, Congress was advised of the inevitable upheaval. Politicians from both sides ignored the warnings by insisting Fannie Mae was solvent, and those who were concerned about the financial market were more concerned with financial safety than housing. Congress' inaction to reel in Fannie Mae's purchasing toxic mortgages, added fuel to the fire, which was about to burn down not only the house, but the neighborhood.

The last issue I want to address is the movie's portrayal that only the three entities mention knew there was about to be a meltdown. There were "shouts from the wilderness" from several sectors, and some even addressed Congress. Free market economists nationwide were sounding the alarm of a bubble. I, along with others, were alerting my students to cash out, and/or sell their notes now. The point is that only regulators, politicians and those defending government were asleep at the wheel and failed to predict the enviable crisis.

In conclusion, The Big Short gave insight into some of the mechanics of the financial crisis. Although the "greed" and frenzy of many in the banking industry was brought to light, the movie failed to indentify the real villains; government regulations, federal laws and Congress' action and inaction. From the passing of the Community Reinvestment Act, to modifying the method of compensation for rating agencies because of political pressure from unions and pension funds, to practically throwing out all competent underwriting procedures for Fannie Mae, the ingredients for a perfect storm were put in place.

However, it should be noted that even with lax borrowing criteria, regulations, and Congressional action or inaction, financial chaos of this magnitude could not have become reality without the Federal Reserve distorting the financial market by setting interest rates far below market value for such a long period of time. Make no mistake; it was the FED and government that triggered the meltdown of many financial institutions, and the bailout by the American tax payers. What gets blamed? Lack of government regulation, of course, even though the Federal Reserve, government regulations, Fannie Mae, and Congress that were the real villains.

There are several economic issues that you should be watching. One is the negative interest rates being proposed. Not good. Another is the amount of debt worldwide that is going bad. Along these same lines, if you are in an area like Montana which depended mainly on the oil industry, be careful of your holdings.

If you have questions or comments, CONTACT ME Tom Henderson /a.k.a. THE NOTE PROFESSOR. It is from your comments that I receive many of my topics.

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