Ron Happe: Good morning everybody, in California that is. Good afternoon, good midday, wherever you happen to be. Today, we're fortunate to have Larry with us. Larry Canfield runs our pricing desk, and I think everybody's aware that's been on here, that the last couple of weeks Larry has been under the weather. So we're glad to have our pricing manager here with us today to give you some of his insight. So thanks Larry for being here today. Glad to see you're back in business.
Larry Canfield: Yeah, well thank you Ron. Not 100% yet, but much better. Glad to be here among the land of the living.
Ron Happe: Well, great. So, if you guys can remember back far enough, two weeks ago I think, we were discussing our exit strategies because exit strategies do play an important role in how we're going to determine a price of an individual loan and of a pool. So our attempt today is to dive fairly deeply into pricing and show you how we make our determinations on what we're willing to pay for a note. And one thing to keep in mind is when we are presented with a pool or a tape, we price every note on the tape. So whether there's 10 or whether there's 100, we price every one of them individually and that's important for accounting in the future when we end up selling these notes.
So we're going to show you, basically, how to price an individual note and you do the same thing whether there was 10 notes on the tape, one note that you're pricing, and we just bought a note this week: one off. So that happens occasionally, or it doesn't matter if there's 200 notes on the tape. You're going to price each note individually and then we will price the pool and if we divide the number of loans in that pool, enter the total price that we get, we'll get what we call a blended rate.
So in order to get started, I'd like to have Larry go over some of the terms and definitions that you really need to understand before you get into the pricing because these are things that you're going to need to know. Again, first of all, let's do the disclaimer. We're not trying to sell you anything. We're not giving you legal or accounting advice. WE recommend that you go to your own counsel for that. And this is for educational purposes only. So, let's go now to Larry and, Larry, can you kind of go through some of the definitions that people are going to need to understand prior to getting into pricing?
Larry Canfield: Sure. Some of the important items when we price a tape would be, of course, the tape itself or the pool, which is defined as a collection of notes, which we would receive from a bank or a hedge fund. The blended rate, as Ron just mentioned, is really the average price of the note on that tape. Essentially, the calculation is taking the total price of the tape and divide it by the number of notes on that tape.
The indicative bid is what we're going to come up with after we've priced each individual note and this is the bid based on the information that the seller has given us in the tape. We don't spend a lot of time upfront on due diligence at this stage of the game in pricing. We rely heavily on what the seller is telling us. We usually only have two or three days to do this, but later, if we are successful in receiving the award of that bid, we are usually given a couple weeks to do more in-depth due diligence.
Fade is something that we need to get involved in sometimes. They might ask us our fade rate, and we might say it's 10% or 20%, which is how much we want to discount incorrect information on the tape. One of the common items on a tape is that fair market value might be way off. I receive and look at a lot of tapes that have appraisals on a tape, and these appraisals might be five years old. So, that's where, as Ron has talked about in the past, the websites can give us some more up-to-date or current price, the Zillow, the Trulia, Eppraisal, Realtor.com. This is a good way to get at the current price.
Color is simply the discount that we are expecting, kind of a tootsy, esoteric term that sometimes a seller might ask you to check your knowledge of this industry. But it's simply what you are expecting as a discount, and this can go to the other extreme. I've seen banks where sometimes they'll just tell you upfront. They'll say, "Here's our tape that has notes and we want par of the UPB on this." And this just kind of tells me that they're probably not serious, they're just shopping around.
So these are some of the definitions, Ron, that we need to consider.
Ron Happe: Okay. Just a comment from this side of the table about those terms. A lot of times you're going to show your knowledge or lack of knowledge when you're talking to a hedge fund, or a lender, just by how you recognize the terms and how you answer a question. For example, if a hedge fund representative were to ask you, "So what's your color on that?" When they talk in those esoteric terms, they're always kind of flags to me that they're trying to determine just how experienced you are in this business.
Again, same thing with fade. The indicative bid can be important because we're not given a whole lot of time to do our due diligence before giving them our first price. And the indicative bid is, it says, "Hey bank. If everything you tell us is true, this is what we would pay for it." So, please just kind of get comfortable with these terms, maybe have conversations with a friend, or a spouse, or a partner, and use these terms, because if you're talking directly to the seller, they're definitely going to be testing you, because that gives them another indication of whether you're going to perform or not.
So now, let's get going here on some actual pricing. Let's dig down deep into the pricing structure and see just how we go about valuing a note, and believe me. We have three pools out that we are selling right now, three mini pools that we have put together to sell, and we are seeing some of the craziest pricing. Actually, we've seen some stupid, stupid pricing from what we thought were sophisticated people that just threw low-ball prices at us, like we had just fallen off a log.
One thing to keep in mind is that when you do throw a price at a hedge fund or a lender and if you do something ridiculous, you're just not going to get offered that opportunity to buy from them again. So, if you're going to put a bid in, put a bid in that is what you're willing to pay. You might put a lower bid in than what you're really willing to pay and have some negotiation room, but don't be throwing stupid prices out to people because in most cases it just infuriates them that they've wasted their time. Now, we have pretty thick skin. It doesn't bother us. We just kind of look at it, shake our heads, and say, "Are they kidding?" But don't be doing that.
So, I bring that up only because these last three pools that we've put out have just gotten several people that have just made stupid bids, and a couple of them were so ridiculously high that we knew that they would never, ever perform. So we hope that you leave here today understanding some of the pricing models that we do. So, okay Larry. Take it over. What makes up the value of a note?
Larry Canfield: Well, we call a P to the third power, property, paper, and people, or the three P's. These general terms go into the makeup of the price of the note. In terms of the collateral [pause 00:11:05], usually when you price a first ... you're purchasing a first, the value of the home is more important, and this is because foreclosure may be your exit strategy. You might end up owning the house and have to sell it to recoup your profit. And we try to grind into pricing all those items that would affect those foreclosure costs: our holding costs, our sales costs, the cost of foreclosure, whether it's a judicial or non-judicial state, and this can vary widely, depending on whether you're in a judicial state.
For example, your costs are generally going to be higher. You might have some legal fees, you're going to have to go to court. And more importantly, it's going to take more time. It might take a couple years to complete that foreclosure. In the case of purchasing a second, the house is not as important. The unpaid principal balance is more important. That's what we look at.
Fair market equity, we define as the fair market value less the unpaid principal balance of the first lien. And when I'm pricing a tape from all the data that we're going to discuss in a little bit, I try to arrive at eventually, what I call a net, net, net fair market equity, which includes all the items that the seller may give us: the first and second lien, back taxes, what are the arrears, what are all the known liens that we can apply, that comes up with whether or not we have a positive or negative equity to deal with that line item with that note. And of course, what does the property look like? How does it conform to the rest of the neighborhood? We make use here of ... Google maps can be very helpful in determining that. The paper that we receive, the note, the deed of trust, these are important. And of course, the payment history is an important item, but how we receive that can vary a lot.
Here's an example of [inaudible 00:13:47] giving us on a handwritten document the payment history for a note. It doesn't give you a lot of confidence in what they're supplying, as opposed to, say, a servicer that has documented the payments and can supply a printout of what their payment history is. The people are very important. What does the borrower look like? The credit report will give you a lot of insight into this. Of course, the borrower can be very important when it comes to buying seconds, which is our primary business ... buying non-performing seconds because we may be able to buy that note at such a discount that we're able to do a workout that can help [inaudible 00:14:46] the buyer in a house. It can even, in some cases, help create some positive equity.
Ron Happe: I would like to make some comments based on this. Now I know there are people that are on the live cast that buy primarily firsts. We buy primarily seconds, and the reason for that we've discussed many times is that we get more bang for our buck. We can buy five, six, seven seconds for what it would cost us to buy one first. But, when you're evaluating and valuing a note, there are different things that you need to look at, when you're valuing a first versus a second. And by far the most important part of the valuation on a first is the property. You must look at the opportunity for your exit. What is it going to be? In the case of a first, the property is the thing that you have to look at because, in most cases, you're going to have to foreclose. Well, I won't say most cases. But in many, many cases, and the only way to get anything off of that is to be able to sell it at the foreclosure or when you do foreclose, to be able to sell it in the marketplace, and that is going to be determined by what the fair market value is. And you'll probably have to take a discount to that, and you'll have your foreclosure, your legal costs, and so on involved.
Now, on a second, by far, the most important ingredient in pricing a second is the people. What does the borrower look like? What do you think when you look at that note? What do you think that you're going to be able to accomplish with that buyer? Are you going to be able to get them to re-perform? Does it look like they, in no case whatsoever, are going to be re-performers? What is their, what we refer to as, emotional equity? How bad do they want to stay in the house? And believe me. If the homeowner wants to stay in the house, you can find a way to keep them there.
Right before we got on the broadcast, I spoke with an investor, and we were discussing the work out on a note that we just sold. And this note was approximately a $36,000-$37,000 note, and the work out with the homeowner was a $200 a month payment, and their interest rate turned out to be 1%. We really don't care about that. We care about what the work out is going to be. So if we could get $200 a month, and to get that $36,000 paid off at a 1% interest rate, it was going to take 201 months. We can turn around and sell that note for returning the investor that buys that note an 18% yield, which is what we did. The investor that bought that note gets 18% on the money they spent and we do quite well. We'll make 100% on that note in less than 10 months, let's say.
So the people are by far the most important when you're talking about seconds. Now, if we could, let's move on then to looking at a spreadsheet that some of the topics, or some of the items, that will be on the spreadsheet. Oops, went too far. So, Larry, do you want to go through the items? When we get a spreadsheet, what do we expect to be on it, and if it's not on it ... we're going to be talking primarily on seconds.
Larry Canfield: Right. Ideally, this is all the information that we want. Sometimes, it's not all there but we would like to receive the fair market value, the credit score of the borrower, the first loan to value. Are the taxes current or not? That may involve a little research. IF they're not, what is the original amount of the first and the second? What's the date that the first is paid to, and what's the next payment due date? The original payment on the second?
Now, we'd like to have the arrears, but if we don't have the arrears, if we have these dates that we just discussed, we can calculate from the last payment to the present what the arrears is. That will help us ultimately in determining whether or not we have some protective equity on that second, which is very important in helping us to arrive at a price. Is the home vacant or occupied? That can have a bearing on the condition of the property. Is the owner in bankruptcy? Are we going to have to talk to the trustee? Are we going to have some legal fees involved? What's the combined loan to value on the first and the second? How many months remaining on the original second? And then, of course, what's the unpaid principal balance on both the first and the second? What's the last payment date on the first? Is the first current?
Now, two of this set of data, we'll transfer it to our own analytical spreadsheet, and we'll add some items in there that will help us calculate our internal rate of return, based on our desired profit, ultimately a target income. And then finally, an offer for each line item that will help us price this tape.
Ron Happe: There's a couple of things when you're looking at this spreadsheet, and usually they will come in the form of a spreadsheet. These headings will be a part of the spreadsheet and let's say that there's 25 notes on the pool, and the fair market value will be listed as what the seller thinks it is. That's probably, as Larry said, the most common place to find discrepancy. There's some things on here that some people, when they first get involved in the business, they look at, we think, way too hard.
For example, a lot of times it's going to be difficult to get a payment schedule or a payment history on a second note from a previous servicer. We kind of take the attitude, "What difference does it make? They haven't paid anyway, they're not paying. What difference does it make if they haven't paid for 30 months or 36 months, only to determine the arrearage?" So, if we just put a number in there, we'll err to the benefit of the borrower, because we know we're not going to collect all that money anyway. And it just doesn't really matter. What matters is, what do we think we can collect on that note? What is a target income, and unfortunately, a lot of that is based upon experience. When you look at a note, you are going to try to determine how much you think you can collect. So, Larry, can you quickly go through how you take a look at this spreadsheet and then utilize the art that you've acquired, so that you can arrive at a price?
Larry Canfield: Well, as you've discussed in the past, Ron, pricing a note is both science and art. The science part is what we're discussing today. That can be taught. The art portion is an experience factor. As Ron has mentioned in the past, this is a business you learn by doing. The more that you price notes, the better off you will be, and the more accurate your bids will be. So as Ron is saying, probably the most important part here on that second is, how much can we collect on the note, which has a bearing on what kind of exit strategy do we use, based on the data that the seller has given on the tape? What is your overhead? Now, your overhead might be different than ours. It's going to depend on the number of employees you have and the tax structure in your state.
If you're an investor investing out of a 401k, you're not going to have much overhead. So, that's a factor in developing how we price. As Ron has discussed before, a certain number of these notes are going to get wiped out. And that's an experience factor that you're going to develop over a period of time. We might have 10%, or 15% of our notes get wiped out. You might have something less or more, but it all boils down to developing a number that works for you, based on your experience. And of course, that's probably going to change over time as you get more experience. What profit do you want? That's the bottom line here when you're pricing, based on your overhead, whether you're a company or you're an individual. What profit margin satisfies your return on investment goals? And then, lastly, of course, what is your exit criteria for pricing this note?
Ron Happe: Before we move on, Larry, let me make a couple of comments about this. First of all, overhead, and just what you're doing in the business, is extremely important because I know private investors that are pretty much running this as just an investment sideline for themselves, and their overhead is pretty much nil. It's just what their time is involved. But you also have to consider you have credit reports, you have charges from Pacer, you have postage, and so on. But I guarantee if you're doing this on your own, your overhead is considerably less than mine. And in that case, you can probably pay more for a note than I can pay for it because we have to cover our overhead.
And the other thing is, how many are going to get wiped out? I would like to address this a bit because this is a major concern when people talk about seconds, is getting wiped out. Well, I guess we have to define "wiped out." There's really only two ways to get wiped out, and the first, of course, is that the first mortgage holder forecloses and there's no equity in the property, and you then are not paid anything, and your lien is basically stripped. The other way is for the homeowner, or the borrower, to declare bankruptcy and there is no equity beyond the first to cover the second, and your lien's stripped, which means that the property is removed from the note. Now in both cases, you haven't been wiped out. You just don't have a secured loan anymore. You still have a note, and that note could be sold to unsecured note buyers, unsecured loan buyers.
And the other thing is, a lot of people get caught up on how much they pay for a note. What you really want to get hung up on is how much profit are you going to make on a note? Do we really care if you pay 20 cents on a note, or if you paid 15% on a note, if you make more profit on the 20 cent note? So keep those in mind. Don't get caught up in your pricing, get caught up on how much profit can we make.
Another thing is that you will have to develop a history. And over a period of time, your history could look something like this, and it will help you identify, what is your target income from a note, if you know that over a period of time, and over a number of notes, that you have certain percentages that are going to fall into a short sale, certain percentages into work out and hold, work out and sell, discounted pay offs and so on. If you can come up with those kind of history numbers, you will be far more effective. So, Larry, do you have comments about that?
Larry Canfield: You might want to discuss ... one of the things that I was ... I've been investing in notes a long time, but one of the things when I joined your company that became a little bit of a surprise to me was that you had a second, and a lot of them are completely underwater, and yet there are investors out there, that will, for the right return of investment, still buy that non-performing note. Would you want to comment on that?
Ron Happe: Certainly. Well we're a buyer of non-performing notes, and when we buy a pool, typically, we will sell off some of those notes to other investors who ... they're not buying in the quantity and at the sum that we're buying at, and they are interested in buying the ... one thing when you're buying seconds, you must realize that the borrower's extremely important.
So, we have notes that we have people paying on, who are 50% underwater. They want to stay in their home. Their children are in school, they like their neighborhood. They go to the 4th of July party every year. They don't want the embarrassment of a foreclosure, they don't want to leave the neighborhood. THey're willing to, if made possible pay. They may have run into a situation where one of the spouses lost a job, or they had a medical expense. Now they're back on their feet again, and although their house may be worth $100,000 and they have a $200,000 mortgage, they really don't want to pay on that $200,000, but they certainly are willing to pay something. And when you buy these notes at the discounts that are available, you have a way to help them stay in their home, and still make a profit at it.
And I will say that if a person does not understand emotional equity, if they just can't get their arms around that, they aren't going to be buying very many non-performing seconds. That is the key ingredient. So the more that you do this, the more comfortable you become doing it, because you work out a history like this.
Larry Canfield: Very good, thank you.
Ron Happe: Yeah, let's go on Larry. Let's kind of get an indication of a pool. And you're going to price a note, and then you'll apply that pricing to a pool.
Larry Canfield: Okay, let's say we have a pool of 10 or 20 notes, and we're now ready to dig in and price, actually, an example here of a single note, one of the line items on that tape. Let's say the original note value was $100,000. The unpaid principal balance is stated as $85,000, so you know upfront some payments have been made. And it is also noted that the first is current now. This is good news, even as it says here the home is underwater. Our purchase price may be such that we can help the owner in this situation even. The arrears has been given to us, or we have calculated it to be $20,000. Now what we will do in a work out is that in exchange for getting the owner to agree to pay some of that arrears, we can then give him new terms on his loan.
So let's say he's agreed to pay 25% of that $20,000, or $5,000, and we've agreed now to ... he's agreed to make a payment of $450 a month. And this could be half or less of what he was originally paying on this particular loan. So, now we've collected $5,000, and let's say we collect 24 payments of the $450, and so there's another $10,800. So after we have seasoned the loan, as we say, adequately, this can then be sold to an investor. In this case, let's say the investor wants a yield of 175 return on his investment and that present value for the remaining 222 months on this is $30,366. So now after 30 months, we have a grand total of $46,166 available to us.
Now, a final step in pricing this is we have to determine what kind of return do we want? What kind of return do you want based on your overhead? And let's say we want a return of 200% over this two year period. So we would divide that by three. That gives us a return of 200% along with our principal, after this period of time which is the $15,388 shown there. One final step is, how many loans is your experience factor going to be wiped out? Let's say, in your case, it's 20%. So we're going to multiply that $15,388 by .8% to give us a 20% reduction and we finally come up with an offer of $12,310 for this line item. So, now we've gone through this, and this is a much better way than just throwing numbers out there, or throwing darts at a board because now we've quantified our risk, and this is going to increase your odds dramatically of success and making a profit, if you're the successful bidder on this tape.
Ron Happe: Okay Larry. Let me draw us a couple questions here. So we know, and I think everybody on the live cast would know, that in order to reduce a $100,000 balance through payments, and reduce that down to $85,000, that this thing had to have been paid for quite some time. I mean, most of the upfront payments are interest, so to reduce that principal is going to take a long time to get down to $85,000. So this note's been in existence a while.
Secondly, wow! First is current. Every time that homeowner writes a check to this first mortgage holder, it's telling us, "I want to stay in my house." So, that's going to have a factor in our valuation. Whether or not the home is underwater really doesn't matter to us if the first is current. That arrears payment, if we know that the unpaid balance is $85,000 in reverse, we can determine how many months it's been paid to get down to that balance, and then we find out ... if we can't find out when the last balance was made, if we know when the payment was written, which we can get off the note itself, or off the trustee, or mortgagee, we can calculate our arrears, and we'll probably make those a little less than they really are. And then through the financials and so on from the homeowner, we think when we're looking at this at first blush, we think that the payment originally on this could have been somewhere in the $700-$800 range, and now we want to make it comfortable.
So, let's say we anticipate that we'll work it out at $450, and so those are all things that we are determining to come up with a price. We're not saying we're going to pay 12 cents, or we're going to pay 15 cents, or we're going to pay 8 cents, or in the case of one of the bids that we got, we're going to pay one cent. There's a reason to come up with a price. And in this case, if we want to earn a 300% yield, or actually 200% and then our capital return, if we divide that total income over 30 months by three, we will get $15,388. That is to get us the profit that we're looking for, and then we apply a discount to that, that indicates 20% are going to get wiped out.
And that's how we come up with a number. We do that for every note on the tape. Now, what would we do if the home were vacant? Well, then we got to figure out that it's probably a foreclosure or a short sale, and we calculate accordingly. And again, so much of it depends on your experience. At the same time, you can make some pretty educated guesses based just on the knowledge you are receiving. Okay Larry, thanks. I think people now have a good understanding of ... sorry about that. That wasn't my cell phone.
Larry Canfield: Sorry about that.
Ron Happe: So, thanks Larry. I think we've kind of given some people ideas about how we go about bidding a pool and getting a price. If you approach it this way, you are going to appear so much more professional than other people that are your competition. Just keep in mind, try to remember that it's not what you pay for a note, it's what kind of profit you're going to get out of that note. That's the extremely important idea to take away from here. We hear quoted all the time, "Well, I'd never pay more than 8 1/2 cents," or, "I'd never pay more than 20 cents." That just doesn't make sense. You have to utilize your profit dollars versus your overhead costs.
When you get good enough and professional enough to do that, then you're going to be buying your share of notes at very good prices. So one more item that we want to discuss is, how long would it take us to do pricing on a pool, so that you can get some kind of idea of what kind of time you should be devoting to it? So Larry, can you give us an idea of how long it would take you to determine pricing on a pool of, let's say, 10 notes?
Larry Canfield: Sure. Not very long. We're first going to take the data we received from the seller, the bank, or the hedge fund, and transfer that to our spreadsheet, which will take us a little time. And we're probably going to spend 5 or 10 minutes at the most, looking at each note, and what is its status? It's going to take maybe a couple hours at most to price that particular tape.
Ron Happe: If you were looking at 100 notes, what kind of time would you devote, that you'd have to slice out to do that?
Larry Canfield: That's another story. IF we're talking 100, 150, 200 notes, and we just allow 5-10 minutes per note, it's a very time-consuming process, particularly if you want to do a good job. And you'll probably take up most of the two or three working days that the seller is going to give you to get that indicative bid back.
Ron Happe: Okay, alright. So we give an indicative bid, let's say, on 100 notes, and we're awarded that bid. What kind of time frame do you think you'd be looking at to do our normal due diligence after being awarded a bid?
Larry Canfield: They usually give a couple weeks. It takes us maybe 10 working days to go through this. And of course, that depends a lot on how many notes are on the tape.
Ron Happe: Okay. Well, I hope that we did some good for you guys in giving you some idea on how to price a loan. If you do have any questions, please give us a shout, or send us an email, and we'd be happy to answer them. I think Larry's a very, very valuable resource, he does a lot of pricing, he's seen a lot go under his bridge. So there isn't hardly anything that he hasn't seen at some point in his career, and I know he'd be happy to address any questions that you may have.
Larry Canfield: Definitely.
Ron Happe: So, again till next week, thank you for attending, and hope you got some good information today. Thanks a lot! Thanks Larry.
Larry Canfield: Thank you.