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[Music] welcome to the note investor podcast we'll guide you through the ups and downs of note investing and teach you all about the nitty gritty details of the business that other people won't talk about your host dan deppen is a former aerospace engineer and product manager who transitioned away from cubicle life to full-time note investing in 2018 our website is www.fusionnotes.com where you can subscribe to this podcast comment and find links to other information on note investing [Music] hi everyone welcome to the note investor podcast i'm your host dan deppen and in this episode i'm going to be talking about forbearance agreements forbearance agreements are something that's been in the press a decent bit lately with covid and everything else going on a lot of the banks have been issuing these and there's a lot of discussion about them in various parts of the media but there's also a lot of confusion around what exactly they are and how they apply so what i want to try to do today is kind of clear up some of that confusion but then also talk about the way that i like to implement these and the structure that i like to use that i've had a lot of success with so we'll kind of start by talking about what a forbearance agreement is or what forbearance is so if we look at the dictionary definition of it it's a temporary postponement of the mortgage payments so basically the lender is granting some relief to a borrower who has an inability to make payments and it's basically an agreement you're coming up with in lieu of just proceeding with a foreclosure overall the reason the lender is going to do this is because the lender thinks they're going to get a better outcome ultimately than just plowing ahead and going through foreclosure and obviously for borrowers who may have hit some kind of a hiccup or a problem where they can't make payments it's an agreement that lets them you know eventually get back on track without facing the foreclosure but there's a million ways that these things can be formed so if you look at some of the ways that lenders will set these up so and this is where a lot of the confusion in some of the news stories happens because people make different assumptions it's generally not just for giving and writing off a certain number of payments although it could be in some cases sometimes it could be the lender's going to just defer some number of payments to the end of the loan and then create a balloon payment at the end the other one that i've heard of recently is sometimes borrower or sorry sometimes lenders are deferring maybe four or six payments but then there's a balloon due at the end of that period so from some of the articles that i've been reading some of the lenders have loans where say they're they're letting the borrower go six months without making a payment but then they're expecting those six payments at the end of the six months which i'm honestly not quite sure how that's supposed to work that seems like a recipe for for problems for everybody um and there are a million other forms of this now the structure that i like to use well before i get into that before i get into my structure which is a little different than those i just want to kind of reiterate that if you're a lender and you're going to grant a forbearance agreement you know remember what your number one goal is and that's that you're looking for a better outcome for you than you would get by going through foreclosure and i've talked about this on several other podcasts but you know if you do take a loan through foreclosure take it back as an reo and sell it your range of outcomes in terms of returns are all over the map because usually when you get the properties back they're usually not in great shape so for me i go out of my way to try to prevent foreclosure because it's expensive cost several thousand dollars um it can take a long time especially depending on the state or you know right now this year with a lot of the courts shut down for a while due to covet and then even now the courts that are back open just being backlogged i'm having a hard time getting hearings scheduled you know foreclosure can be a very long process and it's generally financially never remotely as good an outcome as getting the loan reperforming so really my goal with these is to get into a situation we get the loan back on track i can turn it into a performing loan and then resell it later on so usually i'm going out of my way to try to prevent foreclosure of course it doesn't always work but remember before we dive too deep into this too that there's you have a counterparty on the other side right and then the borrower gets a say and all this as well and so you can create you know the most optimized elaborate forbearance plan that you've analyzed to death um but the borrower may or may not cooperate with it right so you know there's a lot more art than science when you come down to it but just remember that the borrower is always getting a vote so like some of the big things for the borrower that could you know change your plans are do they even number one do they even want to stay in the home you know if the borrower is ready to move on for whatever reason it could be um they're just ready to move they're sick of the whole deal it could be that there's a big crack in the foundation they don't want to live there anymore the roof is leaking or the furnace is dead and we're getting into winter whatever but if they don't want to stay there you know you're not going to be able to get to some agreement that gets them paying again another thing is do they even have the ability to make the payments that you would like them to make i've got one loan right now where they're giving the borrower's situation and you know the value of the house and and the size of the loan there's really there's no scope to come up with an agreement that makes sense um for me is the lender that that the borrower would be able to actually perform on and then another thing to consider is why they were behind on the loan in the first place um so oftentimes borrowers fall behind for reasons that are kind of temporary and they can recover from so for example you know if the borrower got hit maybe with some medical bills it set them back they stopped paying the mortgage they got behind and then you know maybe the the previous lender didn't really talk to them or or work with them and they weren't sure what to do and so they just kind of didn't want to throw money down the drain and then stopped that can be a situation where um you know once the borrower gets through their medical situation they can get back on track divorce is another big one that causes these to go um to go red and stop paying so you know sometimes it's a job loss where they're out of work for a number of months but then they get working again so those situations where the reason for falling behind was kind of temporary mean there's gonna be a little higher probability that you can work something out and get something on track because it you know then it's more likely that they want to stay in the home but they hit some hiccup um you also have to look at what their history has been and track record they're definitely not the majority but you do just get some borrowers who don't like paying their bills right and they've fallen behind because maybe the previous lender just didn't keep on top of things and either follow up with them or foreclose or do whatever they had to do and they just kind of got used to not paying and nobody doing much um you know that kind of borrower is going to be more likely to not follow through in a forbearance plan or get through a forbearance plan and then have problems after that um and then some other things to consider too so as i'll get into this you know usually with these plans i like to have some kind of good faith down payment so do they even have money to do that you know sometimes they don't and then another one is are the borrowers even responsive you know some borrowers you just cannot get a hold of no matter what although i have had some borrowers where couldn't get hold of them wanted to work something out could never talk um started the legal process still couldn't get a hold of them and then to get right to the end where they're about to lose the house then they come online and then all of a sudden they cough up a lot of money to reinstate it's kind of weird but you know if you're trying to reach an agreement with the borrower and the borrower won't even come online and talk well it's a little bit hard to get an agreement in place so sometimes you know despite your best efforts you're not going to be able to do anything but given that just want to kind of explain that now i'll kind of get into the structure of how i like to set these up so my ideal structure is a forbearance agreement i call it slash trial payment plan so so there's really three components to this so with step number one which is the good faith down payment um this is what gives the borrower skin in the game so what you want is it's very what you don't want to have happen is have a borrower make an agreement just as a almost a stalling tactic and then just never follow through so that's why i like to start off with a as large as possible good faith down payment so it gives them skin in the game they've got an incentive to follow through because they're going to lose that payment if they don't and then obviously from a return perspective it's nice if you get a non-performing loan to get this this cash infusion the second part of it is are the trial payments i usually set this up with six to twelve um and the purpose of the trial payment period so the good faith down payment comes first then they're gonna make six to twelve trial payments and this is where the borrower demonstrates that they have the ability to make regular payments so what we're leading to is the loan mod so we want to make sure they have some ability to make payments on a regular basis not just make a one-time payment um and then the third step is to modify the loan and the way that you modify the loan there are a lot of variables you can control there are a lot of different ways you can do that but once you get to the point where you have the loan mod in place now the borrower has a current loan they're at no more risk of foreclosure assuming they don't default again and as the lender you've now got a much more valuable loan because now you've got a performing loan versus your non-performing loan so you can sell this at you know a much higher percentage of the unpaid balance than you would have than what you bought it for and of course there are the and as we'll get into there's some little tricks you can do to actually increase the amount of the unpaid balance as you do this so i'm going to break down these three components a little more and go a little bit more in depth because it's one thing to say with the 3r but then the next question as well what do i actually ask for which of these numbers actually be so starting with the good faith down payment obviously the higher amount that you can get the better most of mine are in the one to two thousand dollar range i've seen them as high as like five thousand that's awesome if you can get it so obviously it's better from the standpoint that you're getting this cash early it helps your return but remember the main thing we're trying to do here is give the borrower skin in the game so that they've got this incentive to follow through and not just peter out not fall through in the forbearance agreement where now you have to go back and foreclose um ideally you know if you're looking for rules of thumb a lot of this will depend on the size of the loan and the payment you know really like to see this be about three times the size of the regular payment and five or six is better so let's say it's like a contract for deed with a 300 350 p i payment you know getting a thousand is not bad although a lot of times i've got 1500 or 2 000 on those um if you go below 3x it's a little dicey although i've had borrowers make no good faith down payment and follow through so it's a little hard to say and again a lot of this comes down to borrower behavior you're never totally sure what they're gonna do you're just trying to stack the deck in your favor but at the end of the day too when it comes to the good faith down payment or forbearance agreements in general sometimes you kind of take what you can get right remember that our goal here is to get an outcome that's better than a foreclosure so for me i might try a forbearance agreement without a good faith down payment even though i know it's pretty flaky and it may not work it can be worth giving it a shot to work so if it does not get the performing loan um the risk is you might be just delaying when you start your foreclosure so but again sometimes two borrowers have really good stories on why they don't have any money to put down the good faith down payment but that they can begin making regular payments now the trial payments um so remember the purpose of the trial payments is for the borrower to demonstrate that they can pay on a regular basis and so i've generally set these up as six to twelve when i started doing these few years ago i mostly did 12. i've increasingly been doing six um and the trade-off there is so from the standpoint of having more trial payments you know the more trial payments the borrower can make you know they're kind of getting more skin in the game as they go along they're demonstrating a better track record so when you ultimately modify the loan there's a little better probability they're going to follow through right if you made it let's say real short couple months you know they might be able to cough up a good faith down payment a couple other payments but then they're not going to stay on track necessarily however the downside of just increasing the number of trial payments as a lender is you know if you're some of this depends on your timeline now if this is just a note that you own say a self-directed ira and you just plan on holding this after it's performing then i might just err on the side of more payments because i'm not really under any time constraints to try to get to an exit you know if you've got if you've taken outside money and let's say you're doing a joint venture or something like that and your joint venture partner has an expectation that they're going to get their money back within i don't know 18 to 24 months then that's a little bit more of an argument to get the trial payment shorter to get to the mod faster so you can get the new loan seasoned and then resell and exit so again a lot of times these things come down to more art than science now modifying the loan this is where it gets really weird and i've got a pretty elaborate spreadsheet that i've built to kind of look at all the parameters so i can tweak some knobs and try to optimize these as best i can it's not a spreadsheet that actually share but uh but i'll explain the thought process behind it so that you can put these together yourself so when you're modifying the loan the one thing you could do is you could just create a brand new loan so whatever you had before was a contract for deed or mortgage you know you could just have the borrower cancel that one and you could create a new one for scratch it could be just a true modification where you're modifying some of the terms of the loan if it's a contract for deed one of my favorite plays is to agree to cancel the contract for deed create a new mortgage and convert it from a contract for deed to a traditional mortgage this is nice from the borrower's standpoint because now they're on title they're not just doing um you know a land contract which it's a subject for another day but to me it's kind of like a glorified rent to own sort of a thing i know it's not lease options are different but you know if you can create a traditional mortgage for them then they're the ones that are entitled they have the sense of ownership they have more rights to it it's a better situation for the borrower and as the lender since a lot of no investors are afraid to buy cfds for various reasons you can sell all things being equal you can sell a performing mortgage for more than a performing contract for deed so that's one of the ways you can increase your value and your sellability of the loan if that is your intention to turn around and resell it you know again if this is something you're holding in an ira maybe users plan to hold on to it then you may not care about that as much but the other benefit to doing that too is if you can go from a cfd to a mortgage you're getting yourself off title and that's nice too because if the borrower starts racking up code violations or utility bills or some of these things where the city and the county come calling to you because you're on the deed so getting off of that can save you some headaches as well um the other thing people do sometimes on these is they just take the other big question is what to do with the remaining or marriages right so if this loan was non-performing there's typically accrued interest perhaps charges for taxes and insurance that lenders have paid over time um and sometimes when people modify these they just tack that on to the back of the loan as deferred principal that's one option i'm not a huge fan of that option um you can also forgive some of your marriages as part of the deal and that can be an additional incentive to get the borrower to follow through so there are a lot of knobs you can turn a lot of options and how you create these talk a little bit about how you can structure these to try to optimize your ultimate return on the loan which is really what your goal is so when we structure the new loan here's kind of my ideal template that i try to use so number one is those are marriages crude interest lender advances late fees et cetera as part of the agreement that i've made up front is i like to roll those into the unpaid balance of the loan so as you may or may not know by now when you're pricing a loan um you always you know especially if it's a non-performing loan you know there will kind of be two values for the balance there's the unpaid balance which is the actual balance and then there's the payoff amount the payoff amount you know involves all these other charges but when you're pricing you always want a price based off the unpaid balance because depending on how well the previous lender and servicer kept records all that payoff amount may or may not be collectible but when we're modifying our new loan if we take those arrearages and can roll them into the unpaid balance now when we go to resell the loan there can the the buyer is considering that entire value instead of just the portion that was the upb previously so that's a big that's a great way to pump up your return especially with some of these loans that have a lot of rear edges in them now at the same time if we're going to increase the balance of the loan you don't want to just have to increase the value of the increase the p i payment right actually have a borrower who at some point was not performing on the old payment you really don't want to raise it a lot because if you do that how do you expect them to perform on that so i try to keep pni of the new loan around as close to the pni of the old loan as i can and so i tend to do that by stretching the loan term out right so from the borrower perspective even though the upb just grew you know these are charges that they're still on the hook for but you've kind of rolled that into the new loan without increasing their payment you just stretch the term a little bit and again you know an additional carrot for the borrower to go along with this could be if it's a contract for d converting it to a traditional mortgage and and getting on title so when you can roll those rearranges into the upbeat alone you can really significantly increase its value and it's one of my favorite things to do to to pump up the roi on my deals all right now again um so the next thing is okay so let's say you've looked at your loan you looked at how far the borrower's behind what the arrears were and you've come up with your perfect plan for your forbearance agreement that includes a good faith down payment of x amount x number of trial payments and then some sort of modification to new to a new set of loan terms right so now you gotta have that discussion with the borrower to see if they're interested and see if they will go along with that or you know have that negotiation so and my recommendation for folks especially when they're newer unless you've had the right training is to have your servicer help you with this there were some vendors i used to use for this previously that were no longer in business but i think the best option is to draft your agreement have a conversation with your asset manager at your servicer and have them approach the borrower and be really clear throughout the whole process um what all of your intentions are with this right so i mean your goal is for the borrower to be back on track it might be to have them on title versus not be on title and that you know your intentions are if you can't get an agreement in place that you are going to follow through on the foreclosure that's a whole other topic for another day is whether um is if you're going to follow through in the foreclosure or not so a lot of lenders will buy a non-performing loan they will try to work out these agreements and if they can't resell the loan that's not my model what i like to do is i'll just take them all to the mat and there are some reasons for that and that's another subject we'll get into another time i don't want to detour too much here but you do want to make it kind of plain to the borrower as well that you're offering a really good deal and an opportunity to get back on track and the alternative is you're going to follow through on this foreclosure so getting the agreement drafted sometimes servicers can write these up for you um but if not have an attorney write it up brian gallagher is really good for a lot of these um depending on what state you're in i like to use franco barely for a lot of these as well particularly michigan indiana ohio illinois and then kind of once you have an agreement in place you can sort of use it as a template but have someone draft this for you i've got one that i like and as things have evolved too and sometimes it's rare but but sometimes i've had borrowers who have had attorneys to help represent them in this and they've come back with different comments so my agreement has kind of evolved over time a little bit and it gets better and better better again like my spreadsheet that's something i don't share but you know talk to your servicer talk to your attorney and see what you need to do to get distracted if you just give them the high level terms of what you're trying to do they can help you put this together so now what happens after let's say you've written your forbearance agreement you've reached an agreement with the borrower maybe the borrower just accepted what you proposed or maybe you know they push back and end up with something a little different than what you originally wanted um what happens now and the big thing is i think you want to monitor it very closely and if the borrower starts to not follow through or they miss a date for a good faith down payment or they're a couple days late on the first payment you want to intervene really quickly um if you get off if they get off track because i have actually not gone back and and looked at my data on the percentage of the time where the bar ever doesn't follow through but a lot of these do fail right i mean these are definitely not a foolproof thing i mean it's like everything right in the loan business i mean the proof is kind of in the pudding i mean my philosophy is whether you're talking about forbearance agreement or a sale of an reo or a sale of a note or purchase of a note you know nothing's ever final until the money hits the bank so just having an agreement does not mean you're there you get to see how well they follow through so a lot of these do fail and what you really want to do is either be you know in some cases what i do is follow up directly myself through either a letter or a phone call but i would only do that if you have the experience and the training and you understand the rules around doing that or have your servicer do that for you but early intervention is really the key don't just let these things go um and sometimes they fail on the first one and then i've tried again and had it go i actually have one right now that we're on the third forbearance agreement and this time it actually seems to be sticking um that's kind of rare um i don't necessarily recommend giving them three tries but you know in this case it's a better it's going to be a better outcome for me than if i just gone through with the foreclosure um and remember too like if you've started legal sometimes what happens in these is maybe you don't maybe you can't get a hold of the borrower and so you send a demand letter and you start the legal process and so maybe it's just like the very beginning of the legal process you send a demand letter sometimes i've had borrowers want to do forbearance agreements once we get really far down the legal process now if you're in that case you're going to want much higher good faith down payments you basically want to get paid back for your legal expenses but do remember if you started legal and then you put an agreement in place and you accept a payment you know if the borrower fails after that you need to start legal all over again so just keep that in mind stay in real close communication with your attorneys and your loan servicers as well so sometimes what happens let's say you've incurred a significant amount of legal expenses and so to justify putting a forbearance agreement in place you need a large good faith down payment let's call it i don't know four thousand dollar good faith down payment you would want to have give your servicer instructions that say hey expect a four thousand dollar down four thousand dollar payment and please accept it i understand this cancels legal however do not accept anything less because what could happen in that situation is the borrower might send in a thousand dollars or a couple hundred dollars like just send in a regular payment and you don't want to accept that and have that mess up your legal process if that's what you need to do um and when we're designing this agreement you know talk about some of the goals a little bit and some of the strategy behind how we're putting these together right so for the good faith down payment it's pretty straightforward you're really just trying to maximize you're trying to get what you can right because it's just better for you you take smaller when you just don't have another choice but then the big one is maximizing the value of the new loan or the modified loan that you've created so rolling as many rearranges as you can into the unpaid balance is really helpful i like to convert to a mortgage if it's a contract for deed and the bar if the borrower is agreeable and if they can meet the dodd-frank rules if you get through the underwriting then that's good you can't always do it you may have a situation where you want to convert it to a mortgage the borrower would like to convert it to a mortgage but their credit's terrible and you can't create a compliant mortgage the other thing you can do to try to maximize the value of your loan is minimize the term um 10 years is kind of ideal so i've had discussions with first national acceptance who will buy performing loans and they said that their ideal scenario for a loan is what they called 10 10 10 so 10 down payment uh 10 interest rate 10 year term now in this case of a modification you know you might have had a good faith down payment as part of a your forbearance agreement but then when you do create the new loan at the back end you know there's not really going to be another down payment there so that aspect of the 10 10 10 doesn't apply and i'm not a huge fan of the 10 interest rates i know some jurisdictions find that kind of ursaris so i'm usually setting it maybe around eight sometimes less it depends and then but the 10-year term is kind of nice so you can basically if you set it up as a 10-year term your pni is going to be higher and all things being equal the loan with the 10-year term is going to be more valuable than loan with the 30-year term again that's probably a topic for another day i don't have time to deep dive into the math behind why that is the case right here um and this remember too is you're designing this agreement right we're always trying to you know to maximize the probability that the borrower is going to follow through that really trumps trying to maximize your potential return right because if you get the borrower to reperform if you can get it to a performing loan you're going to be doing really great almost all the time now if you can optimize it from there you know increase the upb get the loan term just right that's icing on the cake you want to do that where you can but the main thing is maximizing the probability that the borrower is going to follow through so that can be you know trying to get the higher good faith down payment sometimes forgiving or urges can be part of that let's say the borrower has a lot of emerges let's say it's you know forty thousand dollar upb and then ten thousand dollars of a marriages you know you might be able to work something out or say okay if you follow through on this agreement i'm gonna forgive a percentage of their marriages or in an effort to get a higher good faith down payment you may say okay i need a minimum good faith down payment of a thousand dollars and i'll match that in forgiveness of a rear edge's dollar for dollar and if you want to make a higher good faith down payment than that i'll match every dollar you put in dollar for dollar so that can be you can really get your incentives aligned with the borrower that way um and again like i said earlier you know this is a lot more art than science when you kind of get down to it and you're always going to be kind of limited by what the borrower's willing to agree with and what the borrower is going to follow through on as well all right so i'm going to show a couple of quick kind of mini case studies on these because this is really one area where as i started doing more and more of these and learning about them and kind of understanding the math behind them i think i'm a lot better at optimizing them now than what it was a couple years ago i've done some of these where i put them together then we get to the low mod and i was kind of kicking myself because i saw things you know later that that i could have done differently that would have increased the value of the loan so this case study number one i'm not really going to get into the properties and the addresses because that's not really what matters and i'm going to talk about a lot of numbers but i'll try to keep it kind of simple and clear for those that are listening so so this was a note i paid 17 000 for and had an unpaid balance of 43 271 and it had a rear edges of about 5 800. um and the reason for the default was was a divorce so that's actually it's not a good thing but from the lender perspective that's kind of a good reason because that's something people tend to recover from so in this case we got a good faith down payment of a thousand dollars from the borrower and then they agreed to make six trial payments of 621.97 um the borrower completed the plan so we rolled the rear edges into the loan and then by the time you account for you know collecting the good faith down payment the trial payments that came in um our new unpaid balance ended up being right about 46 000 right so we increased the balance from about 46 000 from a little over 43 and we collected a thousand dollars up front and then six payments of 621 so about you know what 46 4700 all together and we got a loan with a bigger upb that's performing now again you know the borrower doesn't always cooperate right after we modify the loan the borrower missed like two payments right off the bat which was brutal because i had already modified the loan so was able to get the borrower caught back up but that did decrease the value that i was able to resell the loan for was able to sell the loan for 26 800 which is not bad i mean it could have been a lot higher than that had the borrower you know follow through directly after we we reset the loan but still if you look at this we're in this for 17 000 and we're getting out a thousand dollar good faith down payment plus six payments is 621 and then sell the loan for 26.8 at the end so the total roi was about 38 um and there was a jv partner on this so they saw half of that they saw 19 percent and the return um this took a little over a year until we did it so the joint venture partners annualized return was 16 and that was after the 50 50 split right and this was not even that ideal scenario we got a relatively small good faith down payment and didn't even resell the loan for nearly as much as i would have liked to so if you really start digging into the math on these you'll see that when you get these reperforming your rois get really good even even with 50 50 splits all right so the second one i'll show so this was a note that i paid 27 500 for the upb was around 45 and they had about 6 300 in a rear edges and i don't actually know what the original reason was for default and so this was one where it couldn't get a good faith down payment out of the borrower and they agreed to six trial payments so this is kind of against all my rules it's very dicey but the way that i view this is i may as well take a chance on this because if the borrower follows through i'm going to do really well and if they don't i'm going to start the legal process anyways and worst case scenario i had a couple months to my timeline not a big deal for a shot at getting it re-performing and in this case the borrower did follow through completed the plan um and then our new unpaid balance ended up being a little over 51 000 seasoned it for six more months and sold it for 33 900. um and again that um as a percentage of upb is lower than what i would like to see on a re-performing loan but the interest rate on the underlying loan was on the low side so that can affect where you can sell it as well um and this worked out to a 24 roi or 12 to the jv partner and then the jv but this was a pretty you know relatively fast deal as well um and so their annualized return ended up being 15 that was even after the 50 50 split so point behind showing you these are just some of the ways they can go you know even if you don't get the perfect deal that you really really want to get um you'll still do really well if the borrower ends up re-performing on them so that kind of wraps up my formula for forbearance agreements if you have any questions please give me a holler i'll talk to you next time thanks [Music] you