Why now is a great time to start investing in nonperforming notes

Bloomberg Businessweek has published an excellent article that describes the favorable economics behind purchasing nonperforming mortgage notes. The article references a former Lehman Brothers exec, David Sherr, who is now running One William Street Capital management LP, a $2.7 billion investment firm and a huge buyer of non-performing loans, or NPLs, tied to delinquent borrowers who haven’t yet lost their homes to foreclosure. A letter to investors released by the firm (also referenced by Bloomberg) states that, in their view, NPLs offer the “cleanest exposure” to housing.

NPN’s are becoming the investment of choice for private equity firms which enjoy MUCH greater latitude than HUD, a major seller of these loans, when it comes to modifying the loan for the borrower. Private equity investors can employ various methods to get the loan “re-performing”– thereby helping the borrower to stay in the home and resume the payment stream. The private investor, having worked with the borrower to get the loan modified, has now repositioned the investment to provide cashflow and thereby added value to the asset. At the same time, with housing prices moving ever upwards, LTVs drop and, since the loans were bought at substantial discounts to begin with from banks forced to charge them off, the investor’s yield skyrockets.

Why the shift to NPNs?

2014-04-14_133257Major factors driving this ongoing mass selloff of NPNs include newer regulations for banks (rendering it extremely cost-prohibitive to continue holding these loans, thusly expanding the already-mushrooming volume of chargeoffs/divestitures), as well as an average 24% increase in housing prices from 2012 which greatly increases the value of the underlying security. At the same time, the inventory of foreclosures (a traditional favorite investment for hedge funds) is now drying up (they’re at the lowest level since 2007) and, alternatively, investment capital is now flowing rapidly to NPNs.

Put another way, NPNs are now at the forefront and assuming center stage as the investment of choice for these billion-dollar hedge fund firms AND there are big opportunities for smaller, individual investors as well who know their way around this market. “The supply of NPLs is going to be very substantial for the next several years,” said Michael Vranos, Chief Executive Officer of Ellington, which oversees $6 billion.

The full article is available online at Bloomberg here.