I’ve previously discussed purchasing a basket of nonperforming second mortgages a few years ago.  Below is a discussion of the reasoning behind the trade. My hope is this will begin to help you better understand how I broadly think about trade construction as well as how I think about the characteristics of underlying assets that make up a trade.

The backdrop was:

1. I’d determined that building houses was not for me (more on this another day, too soon!)
2. I wanted to create a trade with A. downside protection in the event of a market correction but also B. serious upside if housing prices continued to march upward

Unlike originating new loans, where my cost basis would be equivalent to the loan’s unpaid balance, purchasing loans on the secondary market allows for a discount to the unpaid balance, and purchasing non-performing loans on the secondary market allow for a deep discount to the loan’s unpaid balance albeit with a different risk profile.

I initially evaluated non-performing first mortgages.  Three issues kept me from including non-performing firsts in my trade basket. The first and most important was adverse selection. This might have been a function of where I sat in the pecking order of the mortgage world.  Very large funds purchase pools, split them, sell smaller pools to smaller funds, who split them, and so on.  Eventually, these picked-over pools get to onesie twosie buyers like me.  This has all of the elements of an adverse selection problem.  You’re literally getting someone else’s leftovers.  That’s not to say you can’t make money buying a one-off loan from what’s left of a pool, but you better have an EDGE that these funds lacked.  Usually, this edge is deep market knowledge, and a willingness to own and improve the underlying asset.

Notwithstanding the above, I found a second problem with the collateral that I saw among non-performing first mortgages—negative land value.

Stepping back here, I’ve just hopped on Zillow and found a neighborhood and property that typified the kinds of collateral I saw when I looked at non-performing firsts: https://www.zillow.com/homedetails/1128-E-16th-Ave-Columbus-OH-43211/33855803_zpid/

This house is a 3 bedroom 1 bath 1,261 square foot house in the South Linden neighborhood of Columbus asking $109K.  Let’s assume for our example that it’s in turnkey condition.  What would it cost to rebuild this house today? $150 per square foot? Let’s assume by some miracle you could build this house for $125 per square foot.  Ignoring any city fees and any architectural fees it would cost you about $157K to rebuild this house.

The residual land value is negative $48K ($157K less $109K).  This lot has a negative implied value.  Again, this example is just a random house for sale.  The owner may own it free and clear for all I know.  It’s for illustrative purposes so you see the kind of collateral I was looking at.

But you say, when you bought this loan basket, construction costs were lower. You could have rebuilt this house for $110 per square foot!  In that case, the cost to rebuild would have been about $139K. The residual land value still would have been negative $30K assuming the house was worth as much as it is today. But it wasn’t worth $109K then. It would have been worth more like $85K.  The collateral went up in value by $24K over these years but miraculously just as the all-in value of the house and the land together increased by $24K, the implied value of the land, based on this simplified residual land value analysis went from, negative $30K to negative $48K! Time is the enemy of weak loan collateral (CLICK to Tweet THIS).

Negative land value is a problem because it’s hard to destroy land and it’s easy to destroy the sticks and bricks.  As a creditor that owns nonperforming paper, it’s even worse.  The conditions that lead a loan to go non-performing almost ensure that a lot of other things have already gone wrong (deferred maintenance), in the sticks and bricks themselves.  When loan collateral has a negative land value, the one thing that is hard for a borrower to destroy is the one thing that is less than worthless (CLICK to Tweet this).

Conversely, the collateral for the second mortgages that I bought, had land value and were in markets with positive economic/demographic tailwinds.  Again randomly going on Zillow, here’s (https://www.zillow.com/homedetails/431-James-Pl-Saint-Cloud-FL-34769/46297336_zpid/?) a recently sold listing that typifies the kind of collateral that ended up securing the loans I bought–a 3 bedroom 2 bath 1260 square foot house with a garage. It sold for $256K on 7/30/21. If I’m a Florida builder and can build for $150/square foot it would cost me $189K to rebuild this house.  Let’s add another $27K in soft costs for a total replacement cost of $216K.  Even then, the implied lot value is $40K.

When I bought these mortgages, the underlying value of a house like this would have been lower, say $185K.  But the cost to build was also substantially lower then, closer to $115/square foot ($145K) for a regular builder so you see how I would have reached the same conclusion that there was value in the land.  Assuming soft costs were the same, the cost to build back then would be $172K. The lot value would have been about $13K.

The total change in the collateral value over this time period was $71K (from $185K to $256K).  But unlike the illustrative first mortgage collateral that I looked at, the rise in value here was distributed among both the sticks and bricks and the land.  The replacement cost on the illustrative second mortgage collateral rose by $44K (from $172K to $216K) but the lot value also rose by $27K.  This is what you want as a creditor. Time is the friend of strong loan collateral (CLICK to Tweet this).

The third problem with including non-performing firsts in my trade was they lacked a convex payoff structure.  Remember I wanted worst-case downside protection (foreclose, take back the property and rent it) but also upside (bounded but equity-like returns).  I had downside protection although if I took back the collateral for the first mortgages I looked at, my payback period would have been many years. The payback on a second mortgage turned rental would have averaged about a year.

To understand the upside of second mortgages let’s start by looking at the payoffs and loan to values of a non-performing first mortgage based on changes in the underlying collateral value.  This will create a point of reference for us.

In this scenario I’ve bought a first mortgage with a $105K payoff for $75K, spent $5K on legal giving me a cost basis of $80K and a new loan payoff of $110K.  This is secured by a property initially worth $100K.  Ignoring accrued interest and penalties my potential upside is capped at ~38%.

Nonperforming First Mortgage Payoff Matrix
Increase In Underlying Collateral Value	Senior Lien Payoff	My Loan Payoff	My Cost Basis	Collateral Value	Loan to Value	Negotiated Loan Payoff
0%	N/A	110,000	80,000	100,000	80%	100,000
10%	N/A	110,000	80,000	110,000	73%	110,000
20%	N/A	110,000	80,000	120,000	67%	110,000
30%	N/A	110,000	80,000	130,000	62%	110,000
40%	N/A	110,000	80,000	140,000	57%	110,000

Increases in the underlying collateral value predictably lower the loan to value.  There is no lien senior to this first mortgage so the Senior Lien column is blank.  The Negotiated Loan Payoff is a measure of how much a reasonable lender might accept to release the loan.  In this case it reflects that once the underlying collateral increases in value by 10% a reasonable lender (or even an unreasonable one) can’t accept more than she’s owed.

Compare this to the convex payoff structure displayed by second mortgages.

Nonperforming Second Mortgage Payoff Matrix
Increase In Underlying Collateral Value	Senior Lien Payoff	My Loan Payoff	My Cost Basis	Collateral Value	Combined Loan to Value	Negotiated Loan Payoff
0%	155,000	75,000	15,000	200,000	85%	35,000
10%	155,000	75,000	15,000	220,000	77%	55,000
20%	155,000	75,000	15,000	240,000	71%	75,000
30%	155,000	75,000	15,000	260,000	65%	75,000
40%	165,000	75,000	15,000	280,000	61%	75,000

In this case I buy a non-performing second mortgage for $8K and spend $7K on legal giving me a cost basis of $15K. Again in reality this legal spend is over the course of a couple of years so there’s option value attached to legal spend. As reality would have it, collateral values rose rapidly as we at once pressed forward with foreclosures and attempted loan workouts. This mortgage has a payoff of $75K and is behind a performing senior mortgage with a payoff of $155K.  Initially, the underlying collateral value is $200K creating an 85% combined LTV based on my costs.  Yes, this LTV is higher.

But a 10% increase in the collateral value creates a return potential of over 350%+ based on the amount of the unpaid loan balance that is suddenly “in the money.” Likewise a 20% or greater increase in the collateral value creates a 500% return potential.

Lastly, I believed there were mispricings of both first and second mortgages in judicial foreclosure states.  The pricing I observed and conversations I had with those that bought and sold mortgages revealed a time preference for “fast nickels” over “slow quarters.”  I literally heard a couple people use the expression “fast nickels.” Every time I heard it I thought about the famous Marshmellow Experiment. If I wanted a trade that expressed the idea that markets could march higher, while also providing downside protection I needed exposure to “slow quarters.”  That these “slow quarters” were priced more attractively was just gravy.

What do “fast nickel” buyers look for in nonperforming seconds?

1. I found that the most expensive mortgages (asking price as a percentage of collateral value) on the secondary market were in Texas.  You can foreclose quickly and inexpensively with a very high degree of certainty and every buyer knows it.  Incidentally, this suggests that newly originated hard money in Texas is more valuable than most other states.

2. There are plenty of super cheap nonperforming seconds that could be bought for a few thousand dollars but were totally out of the money. Guys that buy these try to do fast workouts with borrowers. The thought is that even a distressed borrower can figure out how to come up with $8K-$10K if that satisfies a $40K debt.

What did “slow quarter” nonperforming seconds have in common. 1. They were at least partially in the money. Secondly, “slow quarter” nonperforming seconds are found in judicial foreclosure states as the foreclosure process there is inherently slower. Consequently half of the mortgages I bought were in Florida, a judicial foreclosure state with a big business cycle (creating both high highs and low lows in real estate or put differently a high volatility real estate market). The big business cycle was also just gravy. If you think of a nonperforming second mortgage as an option to buy the underlying collateral, I wasn’t paying any sort of a premium for the fact that my underlying (the property) in Florida was more volatile than a comparable underlying in say Kansas.

Why am I not buying non-performing seconds today?  I’ve moved further up the capital structure to the security of newly originated and performing first mortgages.  This means I’m accepting a lower potential return, but I believe the risk-adjusted returns are better for performing first mortgages in the world today.

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