One non-performing first lien, two paths valued month by month, and why the bid still belongs to the path that needs no cooperation.
On a non-performing first lien in a slow judicial state, a modification the borrower can afford is usually worth more than foreclosure, provided it performs, because it turns cash in month 37 into cash in month 18. On the fictional Harlow Street loan the foreclosure path supports a bid of $69,754.43 at a 20 per cent return; a 5 per cent, 480-month modification, seasoned for 12 payments and sold at a 9 per cent yield, supports $94,486.54. Bid the floor, not the modification: paid the floor, the modification earns 39.74 per cent.
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 →
Harlow Street is the non-performing note in The Mortgage Note Investor: a first lien, 19 months delinquent, in a judicial foreclosure state. Every figure is illustrative; yields are annual rates compounded monthly.
| Input | Value |
|---|---|
| Unpaid principal balance | 165,619.06 |
| Note rate, contract P&I | 6.25%, 1,108.29 |
| Total debt with arrears and advances | 190,083.45 |
| Value of the house | 212,000 |
| Taxes, insurance and servicing while non-performing | 520 a month |
| Judicial foreclosure: sale at month | 30 |
| Modification signed at month | 6 |
| Borrower's documented P&I budget | 1,050 |
| Payments before resale of the modified note | 12 |
| Buyer's yield on a reperforming note | 9% |
| Required return | 20% |
The note buyer pays 1,700 of acquisition and boarding, then 520 a month until the court sale at month 30, plus 6,500 of legal fees, half at filing and half at the sale. After the sale come three months to possession, cash for keys and repairs, four months of marketing and upkeep, and a sale at month 37 netting 177,444 once a 10 per cent haircut and 7 per cent selling costs come off the 212,000. Discounted at 20 per cent:
Floor = NPV20%(foreclosure flows) = 69,754.43, or 42.12% of UPB
Step 1: the new balance. Arrears are capitalised: unpaid principal, 25 months of interest at the note rate, the advances made by the prior servicer and by the buyer, and the legal fee already spent.
Balance = 165,619.06 × (1 + 6.25%/12 × 25) + 8,075 + 425 × 6 + 3,250 = 201,059.04
Step 2: the payment. At 5 per cent over 480 months the payment is 969.50, 12.5 per cent below the contract payment and inside the 1,050 budget. The highest rate that fits the budget over 480 months is 5.59 per cent.
Step 3: the exit. After 12 payments the reperforming note is sold to a buyer who wants 9 per cent: the present value of the remaining 468 payments, 125,351.03, which is 62.85 per cent of its balance.
Flows: −1,700 at month 0; −520 a month to month 6 and −3,250 of legal at month 2; then 969.50 − 30 servicing for months 7 to 18; plus 125,351.03 at month 18
Value at 20% = 94,486.54, which is 24,732.11 above the foreclosure floor
Excel, the resale: =PV(9%/12, 468, -969.50)
The modification is worth more not because it collects more money. Foreclosure collects more: 140,654 net of every cost, against 128,555. The modification is worth more because it collects it 19 months sooner, and at 20 per cent a year time is the largest cost on the page.
| Path | Payment | Within budget | Resale | Value at 20% | IRR if the floor is paid |
|---|---|---|---|---|---|
| Foreclosure | n/a | n/a | 177,444 | 69,754.43 | 20% |
| Modify, 4% / 480 | 840.30 | yes | 108,646.59 | 80,817.94 | 29.46% |
| Modify, 5% / 480 | 969.50 | yes | 125,351.03 | 94,486.54 | 39.74% |
| Modify, 5.59% / 480 | 1,050.00 | yes | 135,759.25 | 103,003.19 | 45.51% |
| Modify, 6.25% / 480 | 1,141.49 | no | 147,588.63 | 112,682.72 | 51.60% |
| Modify, 6.25% / 360 | 1,237.96 | no | 152,804.23 | 117,499.11 | 54.51% |
Moving the rate from 4 to 5 per cent is worth 13,668.60 of value; moving to the budget rate adds a further 8,516.65. The two most valuable rows are the ones the borrower cannot pay, which is what makes them worthless: a modification designed for the buyer's spreadsheet rather than the borrower's budget re-defaults, and the buyer is back on the foreclosure path having lost a year.
The exit yield moves the answer as much as the rate. For the 5 per cent modification, a resale at 8 per cent supports 104,575.89 and a resale at 11 per cent 78,842.20, a swing of 25,733.68. Seasoning works the other way from intuition: selling after 6 payments supports 99,968.47, after 24 only 85,045.80, because the extra payments do not raise the resale price enough to pay for the wait at 20 per cent.
The common mistake is to bid the modification. A buyer who expects a cooperative borrower and pays 94,486.54 earns exactly 20 per cent only if the modification happens on time, performs for a year and sells at 9 per cent. If the borrower walks away instead, the same price on the foreclosure path earns 11.47 per cent. The book's discipline is to bid the floor, the value of the path that does not need the borrower's cooperation, and treat modification, reinstatement and a deed in lieu as paths you do not pay for. At the 69,754.43 floor, the 5 per cent modification earns 39.74 per cent and the foreclosure earns 20.
The second mistake is to modify at a rate the buyer likes rather than one the borrower can pay. Size the payment from the documented budget, 1,050 here, and solve for the rate and term.
Every path, the blend and the modification designs are live formulas in the free workbook for this case. How the court timeline sets the floor is worked in how much a judicial foreclosure takes off the bid, and pricing a note that is still paying in how to price a performing mortgage note for a target yield.
Capitalise the arrears into a new balance, set the payment from the borrower's documented budget, take the payments for a seasoning period, then sell the reperforming note at a buyer's yield, and discount every flow at your required return. On Harlow Street a 201,059.04 balance at 5 per cent over 480 months pays 969.50, resells for 125,351.03 after 12 payments, and is worth 94,486.54 at 20 per cent.
Solve for the rate that makes the payment on the capitalised balance equal to the borrower's documented budget over the chosen term. For a 1,050 budget on 201,059.04 over 480 months the rate is 5.59 per cent, and that modification supports 103,003.19. A 6.25 per cent rate looks more valuable at 112,682.72 but needs a 1,141.49 payment the borrower cannot make.
No. Bid the foreclosure floor, the path that does not depend on the borrower, and treat modification as upside. If a buyer pays the 94,486.54 modification value and the loan goes to foreclosure instead, the return is 11.47 per cent; paying the 69,754.43 floor, the same modification earns 39.74 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.
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