I love to tell the story about our first exposure to the idea of buying non-performing second mortgages. That’s right, I didn’t just say second mortgages, which probably makes your skin crawl all by itself. I said non-performing second mortgages!
It all started a few years back when Steve and I went to one of the best note conferences in the country to expand our knowledge and meet people within the notes industry. Steve arrived a day earlier than me and had been doing exactly that, learning and meeting those in the industry.
Once I arrived, one of the first things Steve said to me was, “Can you believe some of these people actually buy seconds? That is just nuts. You aren’t going to find me buying any.” At the time, it did sound pretty nuts, but I wanted to learn more.
Fast forward to today, and all we buy are seconds. Steve’s initial reaction is actually on the mild side compared to how other people react to the idea of investing in seconds, which is precisely why they are such a good buy. The negative stigma makes the market less efficient. And, just like any investment, the less efficient the market is, the better your chance for making money if you know what you are doing. Moreover, those who are comfortable purchasing seconds have a leg up on those who aren’t.
This reminds me of when we first started buying properties in foreclosure off the courthouse steps. We spent 90 days watching the process and trying to figure out patterns. I knew that if I could figure out some patterns that we could build systems around, I could outperform and outbid others in the industry. When I couldn’t find those key patterns, I got really frustrated. Then it finally hit me. The lack of patterns is what would make us the most money. The process seemed unpredictable, which kept a lot of people from becoming my competitors. The less efficient the industry, the more opportunity to produce high returns, if you know what you are doing.
It’s the same idea with buying second mortgages. Less people are interested in them because they fear the process. With a perceived greater risk, second mortgages can be purchased at a much greater discount than firsts. This allows for us to purchase more seconds than firsts with the same amount of money. On average, seconds cost us $0.15 on the $1.00 of unpaid principal balance owed which equates to about $11,500 each. For firsts, the average cost is $46,500 and is not based on the unpaid principal balance but the market value of the home. That is a little more than 4 times the cost of a second.
Being able to buy 4 seconds to only 1 first gives us much greater diversification because of the volume of loans we can buy. Diversification is always your friend and your best safety feature. As I have said many times before, “It is a numbers game.”
The other day, a friend told me about this start-up he was thinking about investing in and asked what I thought about it. I told him, “It’s a numbers game, but in this case with a start-up, far riskier.” You need to own small amounts of 20 to 40 different start-ups to be diversified. With start-ups, 1 out of 10 is going to be a homerun, 4 to 6 will do okay but you probably won’t make any money, and 3 to 5 will go bust. If you are only picking one, you better be really confident that it will succeed.
In general, it’s not smart to buy into one start-up. Nor is it smart to buy one non-performing second, or even 10 for that matter. You need the stats on your side. If you flipped a coin 10 times, is it possible to get tails 10 times? You bet it is, but it’s a lot less likely if you flip the coin 100 times or 1,000 times. The odds work in your favor with more volume, but you need to know your odds.
With seconds, we know that when we purchase a tape of loans, an average of 21% will be worth zero. We call these drawer notes. We put them in the drawer and forget about them. What we don’t know is which ones will fall into that category when we are purchasing the tape. Since we price each loan individually, we hope the notes priced lower are the drawer notes. But, unfortunately, we don’t get to cherry-pick the tape.
The good news is, that 21% doesn’t worry us at all because it’s built into our fund’s model. It is just part of doing business in the notes industry, if you know what you are doing.
In case you were wondering, seconds are discounted so much greater than firsts because of a banking challenge. Banks are forced to sell seconds off, especially when they are non-performing. Banks are usually required to have a cash reserve of 10% for firsts and 20% to 30% for seconds, giving them greater incentive to unload seconds off their books. They would rather sell them off for pennies on the dollar than hold the reserves.
Though we currently favor purchasing seconds, it doesn’t mean we won’t ever buy firsts. There may come a day when they make sense for one of our funds to purchase. But for now, seconds give us a much greater return on our money.