Most of the residential loans in the United States today or not owned by big banks. They’re owned by funds. Conservative investors that seek safer investments, in this case real estate-based loans secured by real property, wish to protect and mitigate against downside risk to the portfolio. As most investors see a mortgage fund to be relatively safe, they are usually willing to accept a smaller return on investment.
People tend to see banks as entities with an endless supply of cash. This is not true. Banks “borrow” money to operate. They use money that depositors hold in their bank to lend back out to borrowers. They pay a small amount to the depositor and then charge a bit more to the people that they lend money to. They then keep the difference. Banks also will borrow money from other banks, primarily the Federal Reserve, at an extremely low interest rate known as the Federal Funds Rate. As you can surmise, banks would soon run out of cash if they held on to all of their loans. In order to have liquidity, banks will originate loans and then quickly sell those loans off to the aforementioned funds. They then start the process all over again. One might ask themselves, “but why then do I make my payments to the bank that made the loan. This is an easy question to answer as banks may sell the loan, but many retain what are called “servicing rights” to the loan. In this scenario, the bank collects the payments, keeps a small fee for their service, and sends the rest to the fund that actually owns the note. This process allows banks to have the liquidity they need in order to meet the huge demand for loans.
Many times, a Fund that holds loans will decide to sell some of their loans off. Typically, this will be done in large “traunches” or large pools of loans. When a whole traunche is sold, it usually includes hundreds if not thousands of loans. The sale is certainly much larger than smaller entities can purchase. How, then, can a small group or individual purchase a small amount of loans, or even a single loan. The answer is that many times, these larger funds will sell off small groups of loans that don’t meet their criteria. Enter the “tail” investment.
The tail is an industry slang term that means that small part of the traunche that doesn’t fit the fund’s loan criteria. The fund might seek to only hold loans that are paying as agreed. They might sell of a few loans that are not performing, or paying as agreed. There might be a few loans that have mobile homes as collateral. There might be loans in a state or area that the fund doesn’t focus on. There might be a myriad of reasons why a fund would sell loans. Normally, larger funds sell a larger group of loans than most small investors can afford. Small to medium sized funds then step in and gobble up the group of loans. They often then split up the pool to sell them off “onesy-twosy” fashion for more than they purchased each loan for.
When purchasing a loan from a small fund, they usually will have the buyer complete an application form so the buyer can be properly vetted. When a seller agrees to sell loans to a buyer, they are accepting some liability that the buyer that they sold the loans to will handle the loans appropriately. Keep in mind, the loans files that are being sold, or even shared during due diligence for a sale, contains very personal information of the borrower including income documentation and social security numbers. They can’t just share that information with anyone. You as the buyer, of course, must protect client information with the highest level of discretion and secrecy. The borrower trusted the original lender with their private information. You must treat that trust accordingly. Expect to have to provide information on your company and yourselves when being vetted.
On the flip side, you will be accepting responsibility for the actions of any previous note owner in the chain when you purchase a note. If, for example, a previous note holder make a specific arrangement with the borrower that can be documented, you must adhere to that arrangement. Also, if a previous lender or servicer did anything morally questionable with respect to handling that loan, that’s on you too. You must be careful of who you are buying notes from.
Buying from a fund is a great way to build your note portfolio. You simply need to ensure that you are doing your due diligence as well.