A pool has no yield of its own: it is the sum of its loans, and the loans priced as an average are where a tape quietly takes your return.
Bid a pool of mortgage notes loan by loan: work out each note's own cash flows, value each at your required return, add the values, and only then turn the total into a percentage of unpaid balance. On an illustrative six-loan tape with 540,000 of UPB, the loans are worth 231,193 at a 20 per cent hurdle, 42.8 per cent of UPB. The seller asks 45 per cent, 243,000, which earns 18.04 per cent, and two of the six loans account for the whole shortfall.
Worked in full in The Mortgage Note Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A tape arrives with a single ask, usually a percentage of the total unpaid principal balance, and it is tempting to answer it with a single bid built from averages: average ITV, average delinquency, a blended timeline. That is how a buyer pays for loans it would never buy alone. A pool's cash flows are the sum of its loans' cash flows, so its value is the sum of their values. Value each loan at the hurdle, add them up, and the pool bid falls out. The seller's ask, allocated across the loans, then shows which ones carry the price.
All rates here are annual rates compounded monthly: a 20 per cent hurdle discounts each month's cash at 20 per cent divided by twelve.
| Loan | Type | UPB | Value | ITV incl. senior | Months to resolve | Net recovery |
|---|---|---|---|---|---|---|
| A | First lien, judicial | 120,000 | 140,000 | 85.7% | 30 | 119,800 |
| B | First lien, non-judicial | 85,000 | 70,000 | 121.4% | 14 | 60,400 |
| C | First lien, judicial | 200,000 | 160,000 | 125.0% | 36 | 135,200 |
| D | Second lien, 180,000 senior | 45,000 | 200,000 | 112.5% | 12 | 4,500 |
| E | Second lien, 150,000 senior | 30,000 | 250,000 | 72.0% | 18 | 18,500 |
| F | Re-performing | 60,000 | 110,000 | 54.5% | 60 | 500 a month |
| Pool | 540,000 |
The three first liens resolve through foreclosure and an REO sale: value less 8 per cent of sale costs, less legal and foreclosure costs of 9,000, 4,000 and 12,000, with taxes, insurance and servicing carried at 250, 200 and 400 a month until then. Loan D's property is worth 200,000 against a 180,000 first lien, so after 8 per cent of sale costs there is almost nothing left for the second, and the realistic outcome is a small settlement of 6,000 less 1,500 of costs. Loan E has equity and settles at 21,000 less 2,500. Loan F pays 500 a month and is assumed paid off at 50,000 in month 60.
1. Build each loan's monthly cash flow: carrying costs out each month, the net recovery in the month of resolution.
2. Value each at 20%/12 a month. Loan A: 119,800 in month 30 less 250 a month for 30 months = 67,098.
3. Repeat: B 45,443; C 63,804; D 3,690; E 13,739; F 37,418.
4. Pool bid = sum = 231,193, or 231,193 / 540,000 = 42.8% of UPB.
5. Pool return at the ask: pay 243,000 at month 0, receive the summed cash flows, solve the monthly IRR and multiply by 12 = 18.04%.
Excel, per loan: =NPV(Hurdle/12, Month1:Month60); pool: =IRR(PoolFlows)*12.
| Loan | Value at 20% | % of UPB | Ask allocated | Return at allocated ask |
|---|---|---|---|---|
| A | 67,098 | 55.9% | 54,000 | 28.44% |
| B | 45,443 | 53.5% | 38,250 | 34.70% |
| C | 63,804 | 31.9% | 90,000 | 9.25% |
| D | 3,690 | 8.2% | 20,250 | loses 78% of price |
| E | 13,739 | 45.8% | 13,500 | 21.19% |
| F | 37,418 | 62.4% | 27,000 | 29.79% |
| Pool | 231,193 | 42.8% | 243,000 | 18.04% |
Four of the six loans clear the hurdle at the ask, three of them comfortably. Loan C, the largest balance on the tape, sits at 125 per cent ITV in a slow judicial state and earns 9.25 per cent at 45 cents. Loan D is a second lien with almost no equity behind it: at 20,250 the buyer gets 4,500 back. Together the two are allocated 110,250 of the ask, 45.4 per cent of the tape's balance. Priced at the same 45 per cent, the other four loans alone, 295,000 of UPB for 132,750, return 29.38 per cent.
The gap between ask and bid is 11,807. That is the number to take into the negotiation, and the loan-level table is the argument for it.
| Judicial timeline | Values as tape | % of UPB | Values −10% | % of UPB |
|---|---|---|---|---|
| As tape | 231,193 | 42.8% | 210,120 | 38.9% |
| +6 months | 215,151 | 39.8% | 195,586 | 36.2% |
| +12 months | 200,624 | 37.2% | 182,424 | 33.8% |
The judicial loans are 59.3 per cent of the balance and almost all of the timeline risk. Six extra months of court time take 3.0 points off the pool bid; a year plus a soft market takes 9.0. Neither the 45 per cent ask nor a blended average would show this, because both treat the tape as one loan.
The book's own eight-loan tape, taken apart loan by loan down to the bid, is in the free workbook for this case; the effect of court time on one loan is worked in what a judicial foreclosure takes off the bid.
Only as the last step, after the loans have been valued one at a time. A flat percentage hides that loans differ: in the illustrative tape the six loans are worth between 8.2 and 62.4 per cent of their balances at a 20 per cent hurdle, and the pool comes out at 42.8 per cent of its 540,000 of UPB.
Often you can ask, and the seller can refuse. Priced at the same 45 per cent of UPB, the illustrative tape without its weakest two loans yields 29.38 per cent instead of 18.04, which shows how much of the pool's return those two consume. If the seller will not carve them out, bid the pool at the sum of the loan values, 231,193 here.
It delays the largest recoveries while carrying costs run. In the illustrative tape six more months on the two judicial loans takes the bid from 231,193 to 215,151, from 42.8 to 39.8 per cent of UPB; twelve more months and a 10 per cent fall in values together take it to 182,424, or 33.8 per cent.
This article is one calculation from The Mortgage Note Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.