4/28/13: The Asset Behind the Asset – Finding Gold in Distressed Debt

While many investors are pursuing profits in property foreclosures, fixers and flipping – there’s a small, elite universe of investors doing the same thing and finding gold behind the paper.

Just like distressed properties, the marketplace is full of distressed notes.  That means lots of opportunity for investors who know how to get in on that action.

To find out how the world of distressed debt works, we take a trip to Southern California to spend an afternoon with a guy who deals in distressed debt every day.

If you’re like most investors, you’ve heard stories about the fortunes made in discounted notes.

Then again, if you’re like most investors, distressed debt investing is one of those strange and mysterious activities you’re not quite sure how to actually do in real life.  No worries.  That’s why we boldly go where no talk show hosts have gone before seeking out new ideas and information!

Discussing the details of distressed debt deal making on this edition of The Real Estate Guys™ radio show:

  • Your distinguished host, Robert Helms
  • The dissed co-host, Russell Gray
  • Special guest and distressed debt expert, Michael Soliz

One of the reasons investing in distressed debt hasn’t really hit main street is because sourcing the opportunities isn’t as easy as finding a property.  After all, there’s a real estate agent and loan officer on every street corner eager to help you buy a property.  But there isn’t really a big network of people out there to usher you into world of distressed debt investing.

That’s why we like being us.  As hot shot radio hosts, we just walk into the marketplace and doors magically open.  The next thing you know, we’re sitting face to face with some of the most interesting people in the business.

For this episode, we sit down with Michael Soliz.  Michael has been involved in various aspects of the businesses behind the business of mortgage lending.  And when the mortgage meltdown happened he was right there, behind the scenes, watching how lenders and investors were coming together to clean up the mess…for a tidy profit.  And yes, he was taking notes.  (Ba dum tchhh!)

Once you get your mind around it, it’s easy to understand how you can make money investing in distressed notes.  The harder part is getting in on the action.  It’s even more of a relationship business than the property side is!

But back to how you make money investing in distressed notes…and in keeping with our “no investor left behind” policy, let’s hit the basics.

A “note” is simply the promise to pay – a promissory note.  It’s a liability to the borrower because he owes the unpaid balance to the note holder (the lender) and has to make the payments.  But it’s an asset to the lender, because he gets to collect the money.  So far so good.

Lenders like to lend on real estate because the debt is “secured”.  That means the borrower pledges the asset (the property) as collateral.  This essentially assures the lender that the borrower is going to make the payments or surrender the property (voluntarily or through legal means).  And since real estate never goes down (ha ha), the lender feels safe.

Well, as we all found out on the way to Oz, $#!+ happens.  The sub-prime contagion (you know, the one Bernanke said was “contained”) quickly spread throughout the economy and banks failed, property values plummeted, unemployment sky-rocketed and lots of debt went bad.  Oops.

After the smoke cleared, the capitalists got to work on cleaning up the mess.  Distressed assets are like chum for opportunity sharks…and there’s nothing wrong with that.  It’s how a capitalistic system cleans up problems.  But we’ll save that sermon for another Sunday.

So first, out came all the loan modification entrepreneurs.  They went to work on trying to get the bad debt restructured.  Unfortunately, many of the lenders were in denial and wouldn’t take the hit of reduced interest and principal balances.  Some got done, but nowhere near enough, leaving lots of distressed notes in the marketplace.

Then the Fed pumped the banks full of funny money to compensate for all the bad debt on their balance sheets.  The banks were dead, but hey, let’s put some powder and lipstick on the corpse and no one will notice.

We can debate whether all of that was a good idea or not, but it doesn’t matter. It’s what happened.

Now all of this life support bought the banks some time to feign solvency, while they slowly clean up all the robo-signing improprieties and meter out the dump of foreclosures onto the market.   Think about it.  If they dumped all the foreclosures on the market at the same time, what happens to values?  More downward pressure, leading to even more defaults.  That’s pouring gas on the fire.  So obviously, they didn’t do that.  Better to pull the band aid off every so agonizingly slowly.

Meanwhile, borrowers quickly figured out they could stop paying on their underwater seconds.  Why?  Because as long as they kept paying the first position mortgage, the first lender wouldn’t foreclose.  If the second position note holder wanted to foreclose, he had to pay off the first, which was often more than the property was worth.  And do you think the 2nd position note holder knew that property wasn’t going up in value anytime soon?  Sure they did.

So now the 2nd note holder is the proud owner of a non-performing note with insufficient collateral.  That’s way too much hassle for a note holder.  If they were willing to accept all that brain damage, they’d be the landlord.  But that’s good thing for us, because now they’re getting agitated over having this bad debt on their books.

You with us so far?  We know it’s a lot of buildup, but if you don’t really understand the problem, you won’t be able to understand the opportunity.  If you’ve read this far, we’re guessing you’re motivated.  Good job!  You’ve already outlasted much of your competition, which means more opportunity for you.

That’s one of the great things about distressed note investing.  Most investors would rather climb all over the throngs of other investors chasing the property deal.  They can’t be bothered to learn the art of distressed note investing, which leaves more for those of us who do learn about it.

Now back to our 2nd note holder…

So if you’re the distressed note holder, you’ve got no cash coming in and this embarrassing blemish on your balance sheet.  Worse, you’re expending money trying to collect and account for this note.  And you’re paying “opportunity cost”.  That is, you aren’t able to put your resources to work on other, more profitable activities.

In other words, you’ve become a serious “don’t wanter”.

So you get out the calculator and realize you’ve already collected a lot of interest on the loan (back when the borrower was paying), which was mostly pure profit.  And the borrower still owes most of the principal balance of the loan.  Hey! Why not sell the note at a discount to someone else who’s interested in trying to collect, and take those funds and move on to something you’d rather do?

As Michael explains, all this “distressed paper” (these bad notes) get bundled up and sold in bulk to a deep pocketed investor who gets a healthy bulk discount.

The bulk buyer often turns around and sells a chunk of portfolio (at a mark up) to smaller investors who can’t buy in bulk. (This is where you, as Mom and Pop investor, come in).

But WHY would YOU want to buy a note like this?  After all, it’s underwater and the borrower’s not paying. (Note: (Sorry, we just wanted to put a note in a note)  Not all distressed notes are non-paying, as Michael explains in the interview)

The main reason is because you can buy these notes for PENNIES on the dollar.  And, as Michael explains, there are at least six different “exit strategies” for making a profit on them.  And when you listen through the whole episode, you’ll find out how you can get a bonus podcast where he explains each of those six exit strategies.  Cool, right?

Heck.  Since you’ve already read this far, we think you deserve to be rewarded.  You’re clearly eager to learn about this – and who are we to deny you?  So, click here to access this bonus podcast now.

Obviously, there’s a lot more to learn than we can share on this post.  And since we already have carpal tunnel in both hands, we’re going to sign off so you can listen to this episode on investing in distressed notes with Michael Soliz.  Enjoy!

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