If you’re thinking about investing in non-performing notes (NPNs), also called non-performing loans (NPLs), on owner-occupied residential property, here is how a typical situation plays out.
How a bank sells a package of non-performing notes
A bank, bank holding company or asset management and disposition company puts together a package of, say, 1,000 NPNs and asks for bids. The qualified bidders are major hedge funds, private investment partnerships and private equity funds able to pay $25 million cash or more.
Their analysts are usually finance MBAs who graduated at the top of their class. They’re trained in the most sophisticated financial modeling theories and techniques.
The winning bidder pays for the 1,000 NPNs and takes ownership. Its analysts then drill down into each note to decide which ones will produce a risk-adjusted profit above the fund’s own threshold.
Each round keeps the best and sells the rest
Say the first fund decides to keep 800 notes. It offers the 200 it doesn’t want to another hedge fund or private equity fund with a different risk-return profile.
The high bidder in that second round buys the 200. Its expert analysts examine each one and decide that 150 meet its risk-adjusted return criteria. This fund then asks for bids from retail asset disposers on the rest.
The winning bidder buys the last 50 notes and analyzes whether any of them are worth holding. Say it finds five that the first two funds overlooked or misjudged. It packages those with notes from similar purchases and sells them, along with its analysis, to private investment funds.
| Round | Buyer | Notes bought | Notes kept | Notes passed on |
|---|---|---|---|---|
| 1 | Hedge fund or private equity fund | 1,000 | 800 | 200 |
| 2 | Second fund with a different risk profile | 200 | 150 | 50 |
| 3 | Retail asset disposer | 50 | 5 | 45 |
What reaches the individual investor
That leaves 45 notes out of a package of 1,000. Three professional investment funds, using intensive analysis by highly trained MBAs, have concluded these notes can’t produce even a minimal return.
These are the notes offered to individual investors. According to people in the industry “with something to sell” (the leftover NPNs, training or both), individuals can profit enormously by making them re-performing notes or by foreclosing and selling the property.
The pitch, and why to doubt it
The pitch has two parts:
- “There is plenty of meat left on the bone” (an actual quote).
- If you send the borrower a complete package of all the documents, weighing, say, five pounds, you will “shock and awe” them into paying on the note.
I doubt either claim has even a micron of validity. The people with a financial interest in selling you on this will cite isolated cases of great success. They never mention the far more frequent cases of total failure.
Who makes money, and who doesn’t
At the end of the day:
- The training promoters have collected up to $30,000 per person for their NPN “mentoring” or “coaching” programs.
- The retail asset disposer has made a 50% to 100% profit on its inventory.
- Private middlemen have turned a $2,500 investment in a note into $16,000.
- My sister-in-law, who bought five NPNs more than three years ago and has spent large amounts on attorneys, taxes and brokers, has yet to see a penny in return.
To paraphrase an old saying: if you don’t know who the sucker is in an ultra-high-profit promise, it’s you.
