Ron Happe: Good morning everybody. Thanks for joining us today. We're going to talk about pricing today, but as I intended to have Larry Canfield our pricing desk manager here with us today, but unfortunately Larry is ill and can't be with us. So what I thought I'd do today is go through some of the preliminaries to pricing and this is kind of timely because we have three mini pools out for sale and pricing and let me tell you the pricing has been so ... across the board it just doesn't make any sense in to how some people are pricing the product. We got some pricing that was ... If I would have sent it in I would have been embarrassed, quite frankly. I don't know where these people learned how to price, or if they have. So I'm going to spend today going over some of the preliminary information that you're going to need to do to price, at least to price the way we price. So that number one, you don't embarrass yourself when you are placing a bid on a tape or even on a one-off, that you've got some reason that you can explain to the seller of why you've priced it the way you did.
There's some information, preliminary information that you need to have in order to come up with a bid that number one, is going to be acceptable to the seller and number two, isn't going to embarrass you to the point where they take you off the list and you don't get them anymore. We're pretty thick-skinned here. It doesn't bother us that we get a bid. We got one for a penny, on a behind a performing first in California. Obviously the person either thought we didn't have any buyers out there, or really didn't know how to price a tape. So then next week I'm sure Larry will be better by then. I hope that he will be. We're going to have Larry here and we're actually going to go through the pricing exercise that we use, and when we bid a tape, we price every note in that pool. So we will bid a price for the tape, but every loan that's in that tape will be priced separately and then we follow that price through.
Now there will be times when you are to make an indicative bid, and an indicative bid means simply that if the information that you are using that was provided by the seller is accurate, this is the amount that you'll pay but then you're going to be given time to do due diligence and when you do that due diligence, if you find that there's things that are different than what was claimed on the tape, then you would go back and adjust your bid. So one term that you may run into is, "indicative bid," and another term that you probably will run into is, "fade." The fade is simply the discount to your indicative bid that you might make if you found something amiss or not up to snuff on the tape that the seller sent you. You may fade 10%, you may fade 20%. It's just kind of an esoteric term that the seller may throw at you and oftentimes they'll throw them at you just to see if you know what you're doing.
Another one is, "color." They might ask what your color is on a tape, and what they're typically asking is, "What kind of a discount do you look for?" Or, "What kind of a price would you pay? Are you going to pay 15 cents? You going to pay 20 cents?" That's your color. So when you're talking to a seller, in order for them to converse with you professionally, sometimes they're going to throw some questions at you to just see how much you do know, and whether you're sophisticated, whether you've done this before, or whether this is something that you're doing for the first time.
So I would like just to spend a few minutes with you going over the things that you're going to need to know about a loan before you price it, so that next week we can actually get into the nitty gritty of pricing a loan and then pricing a tape. So I'm going to call up the ... So again, we're going to start all of these with our disclaimer that this is for educational purposes only. Educational and informational. We are not trying to sell you anything. We're not selling securities to you, or anything else. This is strictly educational and we're not acting as an attorney or an accountant. That you should investigate this with your own professional assistance and there is risk in buying notes.
All right, so with that said, let's move on. One thing that you're going to have to realize in this business is that pricing of notes is both a ... it's actually a combination of art and science, and the more you do it, the better you get. Unfortunately this is a business that you learn by doing. You can't just read a book, you can't just take a course, and think that you're going to then all of a sudden be an expert in purchasing, working out, reaching success and then selling a portfolio of notes. You're going to have to get involved actually dong it, if that's your intent. There's a lot of art involved and the artistic part of it comes only with practice. The science you can be taught and we're going to try to give you some of that today, but in large degree unfortunately, this is a learn by doing business. You have to get involved in order to learn it.
The first thing when you buy a note, is you're going to have to know what exit strategies are available to you, prior to your purchase. These exit strategies are going to differ if you are buying a first, versus buying a second. Foreclosure when you own a second note is a very undesirable position to be in. Now in certainly times you're going to be forced to do so. It's not a first choice that you're going to want to do. It's going to be the last resort. It may be you'll have to foreclose even after getting cooperation from a home buyer because there's things that are behind the second. I see foreclosure is spelled wrong there. First thing we probably ought to do is spell foreclosure, but you're going to have to kind of realize that a portion of the tape is going to go to foreclosure. Now there are people that buy these notes with the sole intent of foreclosing.
You'll find that more on first than on seconds, but really our three things that we're going to talk about, we'll talk about them more next week, about the valuing of a note and they are, first of all the collateral. That would be the real estate, the house itself. Again, that becomes more important when you're buying a first, because in many cases the value of the house is what your ultimate goal is if you foreclose. Selling the house or keeping the house for rental or whatever, the collateral is a very important item. In a second it becomes a little less important and the borrower, which is another one of the three points, the borrower becomes maybe even more important than the collateral. Then the third ingredient that makes up the pricing of the loan is the file itself. What does the file look like? You must have a note, with an original signature. You must have all the assignments that follow that note through the different ownerships. You must [inaudible 00:10:22] a mortgage. You just have a [longes 00:10:25] and you should have a payment record of some sort so that you can follow that note from the time it was initiated until the time that you bought it.
Those three ingredients we're going to cover a little more in depth next week when Larry's here, but today I want to let you realize, and know, that the first thing you need to do when you're looking at a note is you need to determine what exit strategy you have. How are you going to make a profit on this note? These are the exit strategies that exist when you buy it. First is the reinstatement, then a discounted payoff, set up a payment plan, that payment plan can include a forbearance. It could be a loan modification. You could do a short sale or you can assist the home owner in doing a short sale. A refinance, now there are opportunities out there in the market today and we have a person at our company that works with home owners.
We buy primarily seconds, and we have a person who works primarily with home owners to get the refinance when they get to the position that they can refinance. Now, years ago refinance was a good way of getting out of these loans. Today, it's very difficult to find somebody that can qualify for a refinance. Either the borrower has a credit rating that's too poor to refinance, or the property is worth less than is owed. However, we work very hard with the home owner, even trying to get their first modified so that they have more money to pay our second. There is also a deed in lieu of foreclosure, where the home owner gives you the deed to the property. You have to be careful on this one. We'll cover that in just a minute, and then there is the foreclosure.
So, we want to talk about reinstating the loan as a stand-alone method of exit and this is where the borrower pays the arrears and the late payments, any penalties, and they start making their payment again, and this would be the same payment they made before, or they could be making a partial payment, but a reinstatement in our nomenclature, in our definition that our company is when the borrower makes us whole. They bring all the arrears current and start paying the loan payments again and I'll tell you, this is a rare occurrence. Doesn't happen very often, but that's an easy one to determine what your payoff is going to be, because you know what the unpaid balance of the note is, and you know what the arrearages are.
One that we see more commonly is a discounted payoff, and this is where a borrower pays less than the unpaid balance as a total payoff; they owe you nothing more. Example would be, let's say that there's an unpaid principal balance on the loan of $49,000 and the lender, let's say that that's us, we purchase this loan and we'll accept a 25% discount on the payoff of that $49,000 as final payment. We accept that discounted payoff of $36,750 and we call that debt paid. This is one that you'll see a lot more often than the reinstatement of the loan of course, or of a refinance. Now there's payment plans that can be made, and this is the most common way that we get our loans performing is through a payment plan.
Basically there are three types of payment plans. There is the forbearance agreement. Forbearance agreement implies that late fees and arrearages, or a portion of those that you agree to with the home owner, they're added to the back of the loan and the time payment is extended, or it could be that a portion of the arrears and late fees are added to each payment and it begins immediately, but most commonly we add arrearages and late fees onto the back of the loan. So let's say that a payment was $400 a month. It would remain $400 a month and let's assume that there was 250 months left on the payment. We would just add, let's say 20 payments of $400 to that 250, so now there's 270 payments left on the note and they still pay the $400 a month. That is a forbearance agreement, where we are forbearing the back payments to the end of the note.
A loan modification is when the terms of the loan are changed and in effect a new loan is written. So, I think a lot of times we'll use the term "loan modification" unwisely and really wrongly. A loan modification is actually rewriting the loan and these loan modifications are recorded. So when the lender, let's say the big bank lender does a loan modification for one of its borrowers on a first mortgage, there's now a new first mortgage on that property, for that borrower and there's no recourse on that first loan. There's a new loan, the loan that was modified is now the loan and that is recorded. We, typically ... One other thing. A loan modification in a new loan is going to fall under origination rules and laws with Dodd-Frank. So you need to be careful when you're talking to somebody about doing a loan modification. Be sure you know what you're talking about.
Now we primarily use work outs and this is where we agree to a new payment plan to put in place and this payment plan must benefit the borrower. We cannot put the borrower into a position worse than that borrower was in before. That benefit could come in the form of a lower payment, we could lower the principal amount, we could lower the interest rate, we can extend the time to get a lower payment, we can make the payment lower, and we do this in a letter form that states that if they default on the work out, if they miss a payment on the work out, then we revert back to the original note and that's the note that we would foreclose on. Work outs are not recorded, they must benefit the home owner or the buyer and they revert back to the original note as a model.
Payment plans are what we use the most as a work out. Then of course there is a short sale. This happens most often when the house is underwater considerably, the homeowner either has decided they don't want to stay, or they cannot afford to stay and we will assist them in doing a short sale. We will find the real estate agent for them, we will manage the sale and we will do the negotiations with the first on the sale. Now buying a second, when you have a second in place and the house is going to be in short sale, you need to be alert and have a very stiff posture on what you're willing to accept from the first, or in combination of the funds that are going to be available, so that you can get your share of your second loan.
Then there is the deed in lieu of foreclosure, where the borrower gives up the deed to prevent the lender from foreclosing. The home becomes an REO and if you are the second holder and you accept a deed in lieu, then you are the owner, subject to the first loan, and that home is now an REO; a Real Estate Owned. One thing you need to be aware of on the deed in lieu, and you need to thoroughly investigate it, is if there is anything behind the second, you are assuming that subject to anything behind it. So, you're taking the property, and you're subject to the property and any judgments or liens that are behind your second. So if there is a third, fourth, three judgments and so on, you've taken those. So in order to do a deed in lieu, you need to get title and get title insurance.
Then of course there is foreclosure. Now in the second world, you're going to start foreclosure on a large number of loans. It's a tool that's used in order to get the home owner to talk to you. Once they see that you are serious. They typically will come around and start communicate with you and want to work something out. In order to foreclose and to see what kind of income you're going to have off that, you need [inaudible 00:22:06] how much it's going to cost you to foreclose, and of course this will vary from state to state. Varies a great deal from judicial to non judicial states, where you have to actually have a court case in order to get someone out of their house in a mortgage state.
So, these are the ways that you can exit a loan and you need to take them into consideration when you start to determine the price you're going to pay for a note. You're going to look at all of these. Now history can paint some kind of a picture, but if you're buying your first note it's hard to have this history. So over time you're going to build up a history and then you're going to be able to determine, all right so I'm looking at this pool of notes and keep in mind the rule of large numbers. This only works if you're buying a large number of notes. If you're buying three, all three could be foreclosures, but as you increase the number that you buy, the historical numbers will start to show. They'll start to show basically in how good you work things out with borrowers, how good you are at selling REOs, how good you're doing with negotiating short sales and so on.
If you take a look at this pie chart, you'll see that foreclosures will probably end up somewhere ... Now this is on a second; a portfolio of seconds. The foreclosures that you're actually going to go through are probably going to be in the neighborhood of 2%. You may go up to 8%, depending upon your willingness to hold the property and where that property is. You might foreclose on a property in Florida and not in Michigan, or in Cleveland there's some markets where you could very easily have a vacant house for a long time. Short sales, deed in lieus could look like 14%, workouts and hold for cash flow 21%. Now again, this is going to determine and next week we'll determine what are you in the business for? Are you in the business to buy and sell after they're performing, or are you in the business to buy and hold? Makes a difference in your pricing.
If you're going to work out and hold for cash flow, or if you're going to do a combination of both, it could look like this. Work out and hold for cash flow 21%. Work out and sell after you've seasoned them and worked them out 23%. A discounted payoff, this is one that you might work heavily at, trying to get your borrower to find funds that you can get out of the loan quickly, sell the loan to one of their family members. We've done that before, as well as letting them borrow money from their family members to pay this off and the family member then gets a new lien on a property. Or you can sell these loans immediately and this is what a portfolio of loans may look like after a period of time when you've built up a number of purchases. So when you are looking at a tape and you can ... kind of ideas about what the loan is going to look like six months after you buy it, you can start realistically putting a price on it.
So next week we're definitely going to discuss utilizing these percentages along with a matrix that's going to include about 25 or 26 properties of a loan that all kind of go into a mix of how do you price it, and what are important? Some of these matrices are certainly going to be geographical. Some of them are going to be the value of the first, some of them are going to be how far is the first behind? Is the first got any equity in it? Is there some collateral in the loan? Is there some equity in the loan? How quickly could you sell the property if you did have to foreclose? What is the status of the first, and so on. All go into make up the price of a loan and it all boils down to we don't really care what the price is, we care what the profit will be and we're going to determine our pricing based upon the profit that we expect to get off of each note.
So I'm hoping that Larry is feeling better. He does this on a daily basis, taking a look at loans and pricing, and I'm sure that he'll have a lot of insight for you. We look forward to being back next week to go through this pricing structure at a very granular, let's say, livecast. So thanks for attending and we'll see you next Tuesday, 10:00 o'clock Pacific time. Thanks again. Bye.