Navigating the Secondary Market


The “Secondary” or the secondary mortgage market is an interesting beast.  It is the place where loans trade for investment purposes.  Let us not confuse the secondary with the retail market.  The retail market is where a potential borrower shops to obtain a loan.  The retail market has a bit more structure and continuity than it’s counter-part, the secondary, as it is regulated to keep borrowers safe from misinformation and unscrupulous acts.  Many investors attempt to navigate the waters alone in the secondary and soon learn it is not all smooth sailing.   

In today’s market many and I mean many folks are looking to loan investing as an investment vehicle as well as an asset to trade or sell.  The participants include the experienced and the inexperienced.  The assets can be of relative quality or they can be complete junk void of possible enforcement and collection. SDXS has been navigating these waters for many years.  We have seen the good, the bad and the worse.  Through our travels we have made a good name for our firm operating with integrity which is supported by our acute understanding of the asset class.  In addition we have developed standards of excellence by which we operate to ensure we only engage in potential transactions which are legitimate and realistic.  This is one of the many reasons SDXS is a partner firm with investors seeking exposure to whole loan mortgages or “notes” as a vehicle for investment.

As a brief glimpse into some of the more persistent and silly ideas about loan trading in the market place we will take a look at these ideas here.  That said, be certain that we do not set out to overly expose every flaw in these propositions as that would simply make it harder to filter out the good from the bad.  Instead we can take a look at some of the common misconceptions and perhaps correct that train of thought.  Thinking about it correctly is really the first step in the right direction.

That brings me to an interesting idea which the picture we have chosen for this blog post reminds me of.  In my office I have what I think is a cool picture.  It is about 2 feet wide by 4 feet tall and hangs on my wall.  I have had this picture for a pretty long time.  So long, I can not really remember where or when I purchased it.  Ultimately it is not an expensive piece of art but the wisdom in the words on the bottom are priceless.  The image is of a lighthouse sitting on a cluster of rocks in the middle of a bay where the ocean is viciously assaulting the area.  The sky is grey and the water is frothy with turbulence.  Yet a lone beam of light emits from this lighthouse toward the on looker.  The caption at the bottom reads as follows:  “We need to learn to set our course by the stars, not by every passing ship.” It is a form of a quote from Omar M. Bradley who incidentally was the last army five star general.  A feat onto itself.  The words resonate with me and our mantra in SDXS.  We do not seek to navigate by those passing ships but rather carve out the proper path to success.

This walks us into our first distinction in the market place.  There are those who intend to actually operate and manage these assets and those who do not.  A party not interested in owning and managing note investments – a wholesaler, if you will – will not be your path through the market.  Working with distressed loans is actually hard work.  Putting a trade together is not an easy nor simple task.  When a party lacks ownership understanding including management and administration it usually results in important elements being omitted or overlooked when it comes note investing.  There tends to be a notion of some form of linear path to loan investing which we would say is an incorrect assumption.  Loan investing is a series of iterations, layers of strategies or a series of action and reaction to those actions.  Details matter.

At SDXS we ask every investor, “What is your investment goal?”.  Most of the answers we field contain expectations of high returns, short investment horizons and at times misguided notions of what it means to be a Mortgagee.  We understand this notion comes from that portion of the marketplace which has zero intention of owning or managing a loan or loan portfolio.  An over simplification and exaggeration of the asset class is what is solicited.

If you have wondered around the secondary for any length of time you have surely bumped into a party who has the “right” connections.  They know all the “hedge funds” who sell loans.  They get “tapes” every week or day.  They can get you the price for “pennies on the dollar”….

All you have to do is simply sign these series of documents which obligate you to pay them and further restricts you from doing business from someone, somewhere who has these prize assets.  You know what we are implying.  The “NCND” and “Fee Agreement”.  Let’s not forget “Principals Only”.

This exercise in paperwork shuffling grossly misses the point.  First, if they have a relationship why are they scared you would circumvent them?  Further, how can we understand a fee, if we do not even understand the assets and their value?  The principals only idea is one of my favorites because in not so many words it takes on the notion that you should by what ever crap I put in front of you.  This over simplifies distressed loans to the idea that they are all the same and the market for the most part is some type of Burger King drive-up window – you can have it your way.  That is not reality.

At SDXS you are not doing business with us because of who we know.  You are doing business with us because of who we are and what we know.  SDXS has a vast experience in making, buying, managing, selling and dispositioning loans.  Who we know is less important than what we know how to do.  To some extent, there is an opportunity in most distressed loans.  The market does not produce loans “your way”.  Nobody calls a borrower or an originator and asks them to create theses specific defects on the loan.  A distress loan by its very definition is a loan which has issues or defects.  Sometimes they have minor issues and sometimes major.  Not all treatments will work.  Nor should all treatments be applied. However, that is why we are here.  A wise man once said, a problem is simply an opportunity in the waiting.

A good partner in the secondary is going to take steps to conserve capital and protect your interests.  That takes an understanding of the asset class that goes beyond knowing any potential counter-party.  Like in the notion of knowing the “hedge-fund” that sells loans.  First, I like to point out my lack of favor for the term “hedge” in the name.  Most of the time what is meant is simply a private investment fund (opposed to public) which invests in whole loan mortgages or notes.  Often times these funds do not actually hedge.  That is hedging an investment usually means to attempt to mitigate risk usually with some form of diversity.  To that degree it would imply a little more of a complex strategy to the fund than what we would expect to see in a fund which simply invests in notes or whole loan mortgages.  For instance, a fund which invests both in MBS (Mortgage Backed Securities) and whole loans at the same time.  The investment into the security is being hedged by owning some whole loans out right or vice versa.  A topic for another time.

The main concern with these settings is we often seek these well capitalized and sophisticated firms as a solution to finding an investment.  Yet we often do so with misguided notions of their sophistication and mastery or lack thereof in the asset class.  Further, these firms typically have large amounts of capital making the engagement one that looks like David vs Goliath.  Truth be told, most investors will never (ever) qualify to do business with some of the larger funds.  JP Morgan is not going to sell a street level investor a single loan or even a pool of loans.  Those firms view that as unnecessary counter-party risk.  Somewhere in that idea is that you will not be as compliant as needed which puts a target on their head from some borrower’s attorney who skips over you to sue them for improper servicing or loan treatment or collection activity.  This concern is void of capital deployment.  That is, even if you have a billion dollars, if you are not established with this asset class you are still a risk to them.

So the point is, do you really understand who the proper counter-party target is for you as an investor.  There indeed are investment funds which trickle sales down toward street level investors.  That said, it is crucial to understand who your counter-party actually is.  Notes or loans do not trade like real property.  There is no escrow to deposit into.  There is not title company to visit and close with.  Any suggestions of these things should create concerns you are not in the right place.  Just because you were told you are seeing assets from a hedge fund, does not mean it is really a well capitalized fund.  Further, if it is a well capitalized fund you will more than likely be the little guy in the equation do not underestimate their level of skill and knowledge when it comes to these assets.  They are not push-overs when it comes to pricing or procedures.  In addition, legitimate funds to not approach trades with a cavalier attitude toward capital.  There are no fire drills where you have to close by tomorrow.  They may understand what you do not and thus they are ditching an asset by selling it to you.  Do not always assume it is some favor.

For this piece, this brings us to the core idea.  As you venture into the secondary to make note or whole loan mortgage investments make sure you are doing it for the right reason.  Loans are typically long term investment vehicles.  They are not ideal short term assets to flip.  In a loan where the borrower maintains their obligation the balance today when is is purchased will be less five years from now.  In other words, they do not lend themselves to a gain on sale.  Be weary of leading yourself to believe you can enter and exist these investments in short time frames.  Refinances are not being handed out like hot cakes.  Resurrecting a defaulted loan to some level of performance does not necessarily mean it has a greater value.  Make sure you are not investing based on those passing ships, navigating the waters by their tail lights but rather seek the right reasons to invest.  Approach the investment with proper expectations and understanding and you will find the path to avoid the rocks.

SDXS works with investors seeking to gain exposure to notes or whole loan mortgages as a vehicle for investment.  Our expertise is in due diligence on distressed loans which you can learn more at Due Diligence & Underwriting.  In addition we also offer solutions for investors who hold larger portfolios or wish to acquire larger portfolios which you can learn more about in our Loan Sales & Trading and Capital Management.  SDXS is capable of creating solutions for investors of all sizes of capital and experience in the market.  If you would would like to learn more or talk to us about our services you can Contact Us Here.

Drop a comment

Your email address will not be published. Required fields are marked *