Note Due Diligence – Are You Doing It Wrong?

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Due diligence is a topic that probably does not get talked about enough in note investing.  Yet it is vital to a successful note investment.  In addition, there seems to be a minimization of both the process and components of due diligence.  This post does not set out to teach you how to do due diligence but rather why you should talk to SDXS about our due diligence service.

I know what you are thinking, another sales pitch, great.  While some of that has truth to it, we do like to promote our services, there is some common sense to what we preach.  Our due diligence service was born from observing the street level investor’s or newbie investor’s plight into note investing.  The desire to learn about note investing has become very popular.  This has opened up the market for seminars, gurus and mentoring programs to grow in numbers.  In addition, the quality of note and the data integrity that gets pasted around has become less than ‘normalized’ as more and more folks jump into the deep end.  SDXS took the same level of diligence we do for own account and offered it to the investing public.  It is a greater opportunity for an investor to have peace of mind and learn about note investing as a whole.

One of the pillars of SDXS was to set out to normalize note investing.  It is actually in our motto: “SDXS helps clients automate, optimize and normalize the analysis, acquisition and disposition of mortgage related assets, resulting in more predictable, profitable and efficient whole loan mortgage transactions and management“.  Unfortunately we do not get to talk about what it actually means enough.  You see the loan market is an interesting place while there is largely a residential market driven by two of the largest mortgage/note investors in the world (Fannie Mae & Freddie Mac).  The market also has some of the largest variances of data sets which those firms require.  Most street level investors are not buying nor are they interested in acquiring loans which would be ideal candidates for those firms.  This opens up the gates to a lack of standard in data as most of the time the street level investor does not know what they do not know and so data presented is assumed to be what is needed.  Certainly not always the case.

Now some of the market has evolved into a little better practice but we still see some of the critical problems in the market place.  The type of loan which is trading in the street level circles is usually a distressed conventional loan, or an institutional grade loan which has some form of defect in paperwork, borrower or real property and warrants a discount.  Additionally the second largest type of loans trading are private loans or loans made by a seller of their own property or for their own capital return.  So by the very nature of the market we have built in deficiencies as to data integrity and content by lack of standards in private lending and by erosion of file in distressed loans.

Distressed conventional loans usually have been passed around a time or two from seller to seller.  This tends to lead to an erosion of file content.  In addition and a large factor are those firms which specifically purchase loans to re-sell those loans down to street level investors.  Now we are glad those folks are in the market to some extent but the lack of a desire to actually work the loan leads to integrity issues in the loan data and file content.  In other words, they themselves do not plan to work the loan so certain points of data end up missing or are less than adequate just by the nature of their process and lack of intended work on the file.

Private loans made by sellers of real property or private lenders can also have their own innate issues as the private lender insinuates a lender who does not make many loans.  Now we do get some reprieve from the new rules out of the Dodd Frank and SAFE Act.  That said, a rule does not make a file compliant by its existence alone.  In some instances, private loans have a bit more of an issue in today’s market as these private lenders turn to less than knowledgeable loan officers and other industry participants to help lessen the gap.  That means thinking everything is proper and good only to find out it is not.

To often it seems due diligence on a loan file is reduced to the idea of checking the value of the real property and some form of title research.  Now those two parts of due diligence are certainly required.  They also carry with them their own variances in the market place.  For instance, over the years we have heard all sorts of silly ideas like do not use a BPO (Broker Price Opinion) vendor instead obtain a less expensive AVM (Automated Value Model).   Further, is checking title as simple as ordering a report?  The report it self does not tell you any specific issue nor how to solve it.  Aside from that point, not all vendors and reports are made the same.

When due diligence is allowed is also not congruent in the market and can be different among sellers.  Some sellers require diligence upfront and for any offer made to them be a final offer.  Others will allow a buyer to bid a loan and conduct due diligence during a set period thereafter.  The prior can put undo stress onto an investor to cut corners and overlook important components to land a trade.  In either setting data and file content can still be missing and ultimately the buyer must beware.

Over the years and in some of our interactions with clients who tried to go it alone, we have seen grossly inadequate file content.  It is easy for a seller to dictate to a newbie investor what they will get and conveniently leave out any idea of what is or maybe missing.  It is not unusual for the seller to not even know themselves (it is not all malicious).  In many of those instances for SDXS we came in too late to actually be able to help the client obtain what they did not have.  Some times the missing competent affects the capacity to enforce the security instrument and collect on the note.  Nobody likes that outcome.

Outside of the two basic ideas in what most can understand in due diligence are many other concepts that are just as important to address.  Who is your counter-party?  Do they own the loan properly?  Is there any legal action being done?  Has any improper servicing taken place which might grant the borrower a defense against your enforcement?  Are the documents and file compliant?

It is both amazing and sometimes unfortunate to hear the reasons or justifications that arise when a potential client contacts us to help them with a file issue.  You see, due diligence is your only diligence.  If you did not catch issues before you purchased the loan you may be in a position of loss already.  As such, it is crucial to get it right from the beginning.

On an institutional level I think many folks would be surprised just how much money a larger investment firm will spend on due diligence prior to purchasing a single loan.  It can be a couple thousand dollars per file.  You see, they understand that it is not a race to the bottom.  There is no award for conducting the cheapest due diligence.  As we know what that can lead to.  You sort of get what you pay for.

Good due diligence serves the investor to protect the investment, ensure they have an asset that is enforceable and collectible.  In addition, it serves as the planning room and launch pad for the loans disposition and possible treatment.  Good due diligence contrasts all the aspects of the trade and the loan not merely two of the parts.  The seller, the file, the borrower, the servicer, the collateral.  It should handle all of it.  Due diligence is not a process of learning for a newbie.  Newer and lesser experienced investors suffer from not knowing what they do not know.  Losing investment dollars because proper due diligence was not conducted is not a smart plan, it is sort silly.

The SDXS due diligence service was specifically opened up to the public to grant access to those investors who wish to make better investment decisions and have peace of mind.  Any investor large, small, new or experienced can take advantage of our skill, knowledge and process of due diligence.  The best way to invest in an industry that lacks normalization is to normalize your investment as much as possible.  This gives you, the investor, the chance to maximize your investment.   That is what we are all trying to do.

SDXS is here when you need us to help with your due diligence needs.  You can learn more about our service at the link Due Diligence & Underwriting.  Or feel free to Contact Us for consultation and inquiry.

2 Comments

  1. Casey
    August 13, 2015 - Reply

    Dion – great article, and more in depth than most I’ve come across.

    When conducting due diligence on a 2nd, how do you determine the status of the 1st (balance, and if it is current)? This seems to be lacking in a lot of exchanges, and something that I feel we need early on to determine the equity position.

    I’m also interested in your mention of the Automated Value Model vs a BPO. I’ll be looking into that as well. Thanks for the article.

    Casey

    • August 28, 2015

      This seems to be a very common questions out there. There is a fair amount of folks trying to get involved in second liens. The answer is a bit tricky. As a Mortgagee (in second lien) you have an interest in the property and level of debt. You can request information from the 1st position Mortgagee and wait for their response. You can also look to the borrower’s credit report and see if the loan is reporting. If it is not reporting (current) then the only place to obtain that information is from the 1st Mortgagee.

      As a bidder you may have issues with pulling credit and running an inquiry with the 1st – you are not an interested party just yet. In that setting you really should put it back on the Seller to provide either the data or some form of authorization to obtain that information.

      To that regard, we realize Seller’s often do not put that much work into their second liens they have for sale and may often just say they do not have the data. In that case, Caveat Emptor.

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