Posted by John Behle on April 29, 2005 at 13:24:10:
In Reply to: John Mendocha in the Paper Game video series posted by Ed James on April 29, 2005 at 11:47:30:
I haven't talked with John in some time, but as I understand it from one of our last conversations, here is what happened.
John started out totally gangbusters in notes and then disregarded some cardinal rules. He started investing in auto notes, but trusted the dealer. The dealer started giving him phoney loans on non-existent cars as collateral. John had borrowed investor capital to do the deals and was left in a bad fix when the dealer took advantage of him.
The two best things about paper investment are:
1 - Very solid collateral.
Real estate doesn't drive off in the middle of the night. In general, over the long term, real estate goes up in value while the loan balance decreases. The collateral actually gets better every day. You have a well-secured loan against an appreciating asset. If a note is bought correctly, then default and foreclosure would actually be profitable. You would have to be at very low loan to value ratios on something like an auto and then hope it was taken care of.
So, first mistake - investing in “in-secure”, depreciating collateral. I've seen a lot of people do this in the note industry. They go after what seems easier, even though they should know better. It’s tempting to run after a deal where someone else does all the work - without considering “why” they might be making their note(s) so easy to buy. A good rule of thumb is “You have to chase after a good note - bad notes chase you”.
Those who profit by investing in something like auto paper have some special skills, knowledge and training and know the rules of that game. For a normal note investor to get into it is almost always an error. High yields can be tempting if someone does not stop to consider why the yield is high and the supply plentiful
2 - Due-diligence and control.
When someone brokers a note, the buyer on the other end makes sure they, their capital and investors are protected. The average note broker has little knowledge or training in this. Very, very, very few courses or seminars out there teach what an investor needs to know. For someone trained as a note broker to buy notes with their own or an investor's money is risky - without the proper additional training.
Over the five day course John took, I teach due-diligence and he was doing very well in the note industry, making some great deals - safely. Then to branch into auto notes loses the advantage of good collateral, but also is a very different game as far as "due-diligence". Even that can be done somewhat safely, but a crucial error happened.
Whether it is real estate notes or auto notes - you can't trust someone to do the due-diligence unless they are a professional that you have hired. To trust an auto dealer to just hand you a note or package of notes and believe that there really is a car there is un-believably dangerous.
The same goes for trusting the seller of a note, a note broker, a real estate agent or anyone else with a vested interest in getting the note sold. In some cases they totally lack the expertise anyway.
You could call it the "Clara Syndrome". When I was new to the business, I was quite stunned by a little old lady real estate broker. She wanted to sell me a property and I was busy. I told her I needed an appraisal and she brought me one - or a photocopy anyway. It was a standard type format with the “subject property” and three “comparables.”
Around all the information of the "subject property" was kind of a gray haze. The type face was a little different too. The sweet little old lady had taken an appraisal from another property, whited it out and put in the one she wanted to sell me. I call that an "Appraisal Du-Jour".
I figured that if a sweet little old grandmother was going to try and defraud me, it wasn't all that wise to ever trust anyone - in that way. I've also had appraisals brought to me where the appraiser was paid off (bribed), given false, inflated information, or displayed extreme incompetence. For example, one appraisal was of a large Victorian home in a desirable area and all the comparables were of other large homes that had been cut up into triplexes. That's comparing apples and oranges.
So, you do your own verification, have your own team, hire your own professionals, use your own people (title company, attny, appraiser), etc. You do NOT trust information brought to you. You can rely on it sometimes to make a “NO” decision or to proceed further - but NEVER long term. For example, if an appraisal brought to me shows a bad LTV, I might save time and decline the deal and move on. If an appraisal shows a good LTV, I might use that to justify pursuing the deal - but at some point I either need to get a new appraisal or do my own.
One very prominent note buyer about a dozen years ago took a big hit and there was a lawsuit over it. I'll call them "Duhhh Mortgage" and the broker "Bouncy the Broker".
Bouncy was brought a note from someone else and brokered it off to Duhhhh for a large commission. It seems Bouncy believed it was the note buyer's job to do the due-diligence and the note buyer seemed to believe it was the note broker's job. Even one simple phone call from the note buyer to the title company or another party could have prevented the loss.
But no, the note buyer, who seemed a little too full of themselves at the time just looked at the documentation and wrote a check. No verification of anything in any way. The note broker who fancied herself the greatest superstar note broker in the galaxy also did no verification or due-diligence, but just passed on the package to the note buyer (funding company). The broker has since left the business and I’m not sure of the Mortgage company.
The only problem was it was a totally fictitious note. Phoney closing statements, title reports, etc. A phone call from either party to the title company would have shown that someone just stole their stationary and plugged it into a typewriter. Basically both parties just trusted the paperwork and blamed each other for not doing their job.
Reality is neither did their job. The note broker should have been more aware and checked things better. Just as a matter of professionalism if not liability. Brokers can and have been sued many, many, many times for notes that go bad or are fraudulent. So, a broker should do two things. They should take extra measures to make sure that they are avoiding bad or fraudulent transactions. But, they should also make it very clear and have signed statements and releases of liability protecting themselves. It needs to be in documentation that the note buyer is assuming all liability, not relying on representations of the note broker or note owner and doing their own due-diligence.
Now, of course, that is with an institutional investor - not a private investor. I don't believe you should ever broker notes to a private investor. I did borrow from them in times past when I first started and didn't have the capital, but I stayed in them middle and maintained control and did an extra careful job of checking out the collateral.
The few times I did broker notes almost always came back to haunt me. A couple cases come to mind. One investor did a lousy job monitoring and collecting their note and then came after me a couple years later when it went bad. In another case, an investor that had taken some other “note broker” course wanted to buy a real nice note. One of my employees arranged the deal or it likely wouldn't have happened. Between the note buyer that thought he knew what he was doing, the bank he was working with that assured everyone they knew what they were doing and my employee whose ego has always far out-shined his knowledge - some things weren't done right.
The note buyer's bank didn't do things right, left out some documents and then everyone was upset when there was problems later. I further compounded it by letting one employee basically beg me to let the original employee handle the problem. Let him have a “victory”. Last I knew the note buyer went away un-happy, though the property went up almost 50% in value in the next couple years. I think he made a profit in the end.
Another investor I had worked with on many notes really soured if for me too. On one of the last notes I sold them they got all upset that I was making a $1500 commission on a small note. Keep in mind, it was a great note and their yield was 21%. They were also very picky and I think they turned down 80% of the notes I brought them - which also requred work on my part. I decided an investor would never again see my end of the deal and what I make.
Then, on another of the notes, the payor fell behind. They called for my advice, then totally ignored it. They had gotten the property back quickly, which was the right step. Then, against my advice, they sold it back to then same person they had just foreclosed on. They also didn't do the other things to protect themselves that I advised. Then right after they let them back in the property, the buyer took out bankruptcy and they had to go through that whole process. Eventually they took the property back and made good money as a rental and then sold for a profit - but of course, blamed me for the problems I had tried to steer them away from.
So, I have to try and make it very clear when I talk about working with private investors that I do NOT broker notes to them, but will borrow based on notes I own or am purchasing (hypothecation). That is not only a great deal safer, but much more profitable and professional.
So, as to John, I'm not sure what is happening with him. My guess is he pulled out of it and moved on. He's very bright and creative, but seemed pretty beat up over all the problems when I last saw and talked with him.
Far too little is taught and talked about in the industry about how to invest safely. Most of the seminars are fluff and hype just geared to create bird dogs for the seminar giver. Even though a few courses might reference how to invest in notes safely, there isn't one I know of (besides mine) that gives a student what they need to invest in notes safely and profitably.
- Re: Auto notes Ed James 16:31:04 4/29/2005 (1)
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