Mortgage Note Investing: Bankruptcy
Let’s cover a basic understanding of bankruptcy and how it relates to investing in mortgage notes. We’ll start by defining a critical document called the proof of claim. A proof of claim, in bankruptcy, is a document filed with the court to register a claim against the assets of the bankruptcy estate.
The claim sets out the amount that is owed to the creditor as of the date of the mortgage note bankruptcy filing. A proof of claim will outline the debts that are secured and the debts that are unsecured. Secured debt is debt backed or secured by collateral. In a case of a mortgage, if the borrower defaults on repayment, the bank seizes the house, sells it, and uses the proceeds to pay back the debt. Just as there are performing and non-performing notes, there are performing and non-performing bankruptcy notes. And there is a mixed view about whether performing bankruptcy loans are more attractive than other types of performing loans.
A reliable performing Chapter 13 loan is viewed by some investors as a great opportunity because the borrower’s financial situation in some cases has finally been cleaned up. Additionally, the cash flow from the arrears can boost the return. Arrearage or also referred to as arrears is the amount overdue on loan. Under a typical BK, the borrowers are catching up on the arrears while also making the contractual payment that they were supposed to be making before they filed for bankruptcy. In other words, there are additional cash flows from the original payment plus the amount that’s being caught up. Now the technical terms for these types of payments are pre-petition or contractual payment and post-petition or plan payments. Let’s talk about some considerations with a non-performing bankruptcy loan. During bankruptcy, most collection efforts cease due to what’s called the automatic stay. When a creditor wants to continue to collect from the debtor during the bankruptcy, it can seek permission directly from the court to do so—known as lifting or getting relief from the automatic stay. Creditors must do this by filing a motion with the court, and that motion is called a motion for relief. You might hear this referred to as an MFR. It’s important to note that there are restart states and non-restart states concerning foreclosure. This determines whether the creditor can resume the foreclosure from the point where it left off just before the borrower filing bankruptcy.
Restart states are typically preferred by lenders because they can complete the foreclosure quicker and after they’ve gotten relief on the bankruptcy. One thing to look out for is a repeat filer, which are borrowers that filed bankruptcy multiple times to block the foreclosure.
To recap the big ideas: The key pricing variables for performing loans are credit, the note rate, the loan to value which determines the equity position, and the payment history. The key pricing variables for NPL or non-performing notes are the value band, the geography, the loan to value, and the stage of foreclosure.
There is a higher demand for notes in the higher value band range amongst the institutional investor. Conversely, the lower value band tends to be more attractive to individual investors. Finally, while some investors may steer clear of bankruptcy files, there is an opportunity for investors that understand the nuances.
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