It’s 9:30 a.m. on a recent sunny Friday, and 60 people have crammed into an airport hotel conference room in Northern Virginia to hear Kevin Shortle, a veteran real estate professional with a million-watt smile, talk about “architecting a deal.”
Some have worked in real estate before, flipping houses or managing rentals. But the deals Shortle, lead national instructor for a company called Note School, is describing are different: He teaches people how to buy home notes, the building blocks of housing finance.
While titles and deeds establish property ownership, notes — the financial agreements between lenders and home buyers — set the terms by which a borrower will pay for the home. Financial institutions have long passed them back and forth as they rebalance their portfolios.
But the trade in delinquent notes has exploded in the post-financial-crisis world. As government entities like Fannie Mae and Freddie Mac have struggled with the legacies of the housing bust, they’ve sold billions of dollars’ of delinquent notes to big institutional investors, who resell them in turn.
And people like the ones in the Sheraton now pay good money to learn how to pursue what Note School calls “rich rewards.” The result: a marketplace where thousands of notes are bought and sold for a fraction of the value of the homes they secure.
A buyer can renegotiate with the homeowner, collecting steady cash. Or she might offer a “cash for keys” payout and seek a tenant or new owner. If all else fails, she can foreclose.
For some housing market observers, the churn in notes is a sign that the financial crisis hasn’t fully healed — and a fresh source of potential abuses. But the people listening to Shortle saw opportunity as he explained how they can “be the bank” for people with mortgage-payment problems.
“You can make a lot of money in the problem-solving business,” Shortle said.
How home notes move through a healing housing market
Since most people buy homes using mortgage financing, notes can be thought of as another name for mortgage agreements. After the home purchase closes, banks and other lenders usually sell them to government entities like Fannie Mae, Freddie Mac, and the Federal Housing Administration.
The housing market has improved since the bust, but hasn’t healed fully. There were 1.4 million foreclosures in 2015, according to real estate data firm RealtyTrac, and more than 17% of all transactions last year were deemed “distressed” — more than double pre-bust levels — in some way.
As the dust has settled, government agencies have begun selling delinquent notes to big institutional investors like Lone Star Funds, Goldman Sachs GS, +1.83% and Fortress Investments FIG, +2.18% as well as some community nonprofits, in bulk. The agencies have sold more than $28 billion in distressed loans since 2012, according to government data.
The big investors then sell some to buyers such as Colonial Capital Management, which is run by the same people who run Note School. Colonial, which buys about 2,000 notes a year, sells most of them one by one to people like the ones who gathered in the Virginia Sheraton.
It’s difficult to know how much this happens and what it has meant for homeowners.
Anyone who buys notes from the government must follow reporting requirements that include information on how the loans perform. Those requirements stay with the notes if they’re resold; they expire four years after the government’s initial sale. But nobody tracks note sales that weren’t made by the government, and even the government’s records don’t link outcomes and note owners.
March data from the Federal Housing Administration only hint at a broad view of how post-sale loans perform. The FHA has sold roughly 89,000 loans since 2012; less than 11% of those homeowners now pay their mortgages on time. Many are simply classified as “unresolved.” More than 34% had been foreclosed upon.
Fannie Mae and Freddie Mac, which began selling notes in 2014, were supposed to report similar data by the end of March. A spokeswoman for the agencies’ regulator said she did not know when that report, still incomplete, would be submitted.
And not all notes are initially sold by the government, making comprehensive oversight of the marketplace even harder. Banks and other lenders often sell notes directly; Colonial doesn’t buy notes from the government, according to Eddie Speed, founder of both Note School and Colonial.
For investors, a cleaner deal than the world of ‘tenants and toilets’
Note buying has attractions for both investors and the communities where the homeowners live.
Delinquent notes can be bought cheaply, often for about a third of a home’s market value. Note buyers get an investment that’s more like a financial asset — and less dirty than the landlord’s world of “tenants and toilets.”
Meanwhile, investors can often afford to cut homeowners a significant break, avoiding foreclosure while still making a profit.
And there’s government money for the taking in the name of helping homeowners. Since the housing crisis, the federal government has allocated nearly $10 billion to states deemed hardest-hit by the bust. Those states funnel the money to borrowers, often to help them reach new agreements with their lenders.
That can help municipalities that lose out on property taxes when homeowners don’t make payments, and which benefit from having more involved owners, Speed says.
When Tj Osterman, 38, and Rick Allen, 36, who have worked together as real-estate investors for about 10 years in the Orlando area, first explored note buying, they thought it little different than flipping abandoned houses.
But when they realized homeowners were often still in the picture, they changed their approach to try to work with them. Some of their motivation came from personal experience: Allen went through foreclosure in 2007. “It was a tough time,” he said. “I wish there was someone like me who said, let’s help you keep your house.”
They can buy notes cheaply enough that they can reduce the principal owed by homeowners “as much as 50%, and still turn a nice profit, pay back taxes, [and] get these people feeling good about themselves again,” said Osterman.
They now have a goal of helping save 10,000 homeowners from foreclosure. “I’m so addicted to the socially responsible side of stuff,” Osterman said. “We talk with borrowers like human beings and underwrite to real-world standards.”
‘There’s a system out there that’s broken’
Some housing observers have concerns about drawing nonprofessionals into an often-opaque market. A recent example Shortle used as a case study during the Virginia seminar helps explain why.
A note on an Atlanta-area home was being sold for $24,360; according to estimates from Zillow and local agents, its market value was between $50,000 and $70,000.
Some back taxes were owed, and a payment history showed that while the homeowner was making erratic or partial payments on her $500 monthly mortgage, she hadn’t quit. She had some equity built up in the house, another sign of commitment.
Real-estate investment firm Stonecrest sold her the home in 2012; she had used Stonecrest’s own financing at 9%. Her payment record was spotless until 2014. Stonecrest sold the note to Colonial in 2015 and Colonial offered it for resale in early 2016.
Most notes underpin mortgages. But this one was linked to a land contract, a financial agreement more typical when the seller is offering financing. Land contracts are sometimes criticized for being almost predatory: If a buyer skips a payment, the house and all the money he’s put toward it can be taken away.
And buyers don’t hold the deeds to the home, so the homes can be taken more quickly if they’re delinquent. Note School often steers students to scenarios where government programs like Hardest Hit can be tapped, but those programs don’t apply to land contracts.
Shortle walked his class through different strategies. The new note owner could foreclose; they could also induce the home buyer to walk. “It may be time to give this person a little cash for keys to move on,” he told the class. “They can’t afford it.”
Other data indicated that the house would rent for roughly $750. It might make sense, Shortle suggested, to remove the homeowner, fix up the house, rent it out, then sell the entire arrangement to a cash investor.
If a new note owner took that tack, the note would change hands four times in about as many years—even as the homeowner changed just once. The homeowner might never notice.
Some analysts see evidence of a still-hurting housing market behind all that activity.
By diffusing distressed loans out into a broader marketplace, lenders avoid the negative publicity that comes with foreclosing on delinquent homeowners. That masks “a layer of distress in the housing market that’s being overlooked,” said Daren Blomquist, vice president at RealtyTrac.
“This has been a way to push aside the crisis and sweep it under the rug,” Blomquist told MarketWatch.
Blomquist acknowledges Speed’s philosophy — that a new note owner might be motivated to come to far better terms with a struggling homeowner than a large investor — but says there are still potential pitfalls. The sheer volume of notes the government is selling off is unprecedented, he says, and the opacity of the secondary market creates “a fertile ground for abuses.”
Julia Gordon, executive vice president at the nonprofit National Community Stabilization Trust, agrees. “This is part of the shadow banking industry that continues to interface with vulnerable homeowners, and for that for reason I think it’s of policy concern,” Gordon said.
Gordon also questions the notion that individual note owners are friendlier to distressed homeowners than large institutions. She fears that the lack of regulation might allow “the same type of predatory lending that preceded the crisis to flourish” with virtually no oversight.
There’s another, subtler, concern about the buying and selling of home notes: It mimics aspects of the subprime lending boom that crashed the housing market.
Each time a note changes hands, there’s a flurry of activity: Realtor valuations, lawyer fees, title searches, and so on. But Blomquist sees it as churn — a way of addressing the “political desire” to keep homeowners from foreclosure that adds little value to the housing market.
Gordon sees another, troubling, similarity: The subprime boom relied on a steady stream of home purchases, often revolving around a not-very-savvy borrower, to keep the financial markets sated, and she views the current traffic in notes as little different.
At its center, she says, is a borrower whose best option for buying a home was 9% financing in an era of rock-bottom interest rates. Now that note is being swapped among traders hungry for a financial asset, not a home.
In this market, discussion of the assets that secure the financing is detached from the considerations that usually accompany discussions about real estate: faulty boilers, leaking roofs, subpar school districts, and so on. As Note School makes clear, it is teaching students to be the bank, not the landlord.
‘There’s a system out there that’s broken and needs to be disrupted in a good way.’
Federal regulators opted not to answer questions about the growing secondary market in notes. A spokesman for the Department of Housing and Urban Development, which oversees the FHA, declined to comment for this article
A spokeswoman for Fannie and Freddie’s regulator, the Federal Housing Finance Agency, said in an email that “continuing to responsibly reduce the number of severely-aged delinquent loans and improve borrower and neighborhood outcomes are priorities” and noted regulations regarding reporting and treatment of delinquent borrowers, but declined to say more.
Note investors say they can offer a service others can’t or won’t. “There’s a real issue with how we’re treating hardships,” said Osterman. “There’s a system out there that’s broken and needs to be disrupted in a good way.”
Note School’s founder says the goal is a ‘win-win’
While newer investors like Osterman and Allen have a sense of mission forged during the recent housing crisis, Speed has been in the note business for more than 30 years. He is adamant that it’s in Note School’s best interest to teach students to observe regulation and treat homeowners respectfully. There’s no reason it can’t be a “win-win,” he said.
‘We’re not teaching people to go and do ‘Wild West investing.’
Colonial Funding doesn’t make buyers of its notes go through Note School, but it does require them to work with licensed mortgage servicers. Note School offers connections to armies of vendors offering services for every step of the process: people who will assess the property’s real market value, “door-knockers” who will hand-deliver letters to homeowners, title research companies, insurers, and more.
“We’ve been in the note buying business for 30 years,” said Speed. “We’re not teaching people to go and do ‘Wild West investing.’”
Speed believes buying distressed notes is a process tailor-made for people with an entrepreneurial approach to doing well by solving problems — and maintains that he is mindful of the postcrisis environment in which they work.
“I’m walking into where the disaster has already happened,” he said. “If I walk into a loan where the customer has vacated, they probably want out. Common sense tells us if the borrower can deed it over to the lender and walk away with dignity, that seems like a good deal for him. We’re trying to do everything we can to reach resolution.”