Buy, modify, season, sell: how the buyer's yield falls with payment history, what that does to the exit price, and what a re-default does to the return.
A re-performing note is priced on its remaining payments at the yield a buyer demands, and that yield falls as the borrower builds a payment history. In an illustrative modified loan paying 839.37 a month, the note is worth 66,383 the day the modification is signed, at a 15 per cent buyer yield, and 91,301, or 66.0 per cent of its balance, after 12 on-time payments at 10.5 per cent. Twelve months of seasoning add 24,919 to the exit price before counting a single payment collected.
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 →
This is the arithmetic behind the most common non-performing note strategy: buy the defaulted loan cheaply, agree a modification the borrower can afford, let it season, then sell it to a buyer who wants yield rather than workout risk. How to value the modification path against foreclosure, at a single resale yield, is worked in modify or foreclose a non-performing note; here the question is how the resale yield itself changes with payment history. The modification is where the work is; the seasoning period is where most of the value is realised, and also where the risk sits.
| Input | Value |
|---|---|
| Unpaid balance of the defaulted first lien | 150,000 |
| Purchase price (40% of the old balance) | 60,000 |
| Modification, legal and onboarding costs | 3,000 |
| Modified balance, rate and term | 140,000 at 6.0%, 360 months |
| Monthly payment / servicing fee | 839.37 / 30.0 |
| Buyer yield by months of payment history: 0 / 6 / 12 / 24 | 15.0% / 12.5% / 10.5% / 9.5% |
All in, the investor has 63,000 in a note with a 140,000 balance, 45.0 per cent of the new balance.
Monthly payment = 140,000 × 0.50% ÷ (1 − 1.005−360) = 839.37. In Excel: =PMT(6%/12, 360, -140000).
Exit price after k payments = PV of the remaining (360 − k) payments at the buyer's yield. After 12 payments at 10.5%: =PV(10.5%/12, 348, -839.37) = 91,301.
Balance after 12 payments: =-FV(6%/12, 12, -839.37, 140000) = 138,281, so the price is 66.0% of balance.
Investor IRR: month 0 −63,000; months 1 to 12 +809.37 net of servicing; month 12 + exit price. =RATE(12, 809.37, -63000, 91301)*12 = 50.8%.
| Months of payments | Buyer yield | Exit price | Balance | Price % of balance | Payments collected, net | Profit | IRR |
|---|---|---|---|---|---|---|---|
| 0 | 15.0% | 66,383 | 140,000 | 47.4% | 0 | 3,383 | n/a |
| 6 | 12.5% | 78,523 | 139,153 | 56.4% | 4,856 | 20,380 | 59.0% |
| 12 | 10.5% | 91,301 | 138,281 | 66.0% | 9,712 | 38,014 | 50.8% |
| 24 | 9.5% | 98,531 | 136,456 | 72.2% | 19,425 | 54,956 | 35.2% |
Selling the day the modification is signed barely covers costs: a buyer of an unseasoned modification is buying the re-default risk and prices it at 15 per cent. After 12 payments, the same cash flows sell at 10.5 per cent, and the profit rises to 38,014 on 63,000 of cost. Waiting to 24 months makes more money, 54,956, but the IRR falls to 35.2 per cent, because the yield compression slows while capital stays tied up. At the other end, a sale after six payments has the highest IRR, 59.0 per cent, but earns only 20,380, so the choice of exit month weighs IRR against profit per deal and how fast the capital can be redeployed. Holding the note to term would earn 15.3 per cent, which is roughly what an unseasoned buyer asks: the flip is a bet that the market will pay for a payment history the investor has created.
The table above assumes every payment arrives. Suppose instead that 30 per cent of modified borrowers stop after six payments, and the investor then forecloses, recovering 90,000 from the property at month 24 less 8,000 of extra legal cost, 82,000 net.
| Re-default probability | Expected profit | Expected IRR |
|---|---|---|
| 0% | 38,014 | 50.8% |
| 15% | 35,809 | 43.6% |
| 30% | 33,605 | 37.1% |
| 50% | 30,665 | 29.8% |
The re-default branch is still profitable here only because the note was bought at 40 per cent of the old balance against a property worth 90,000. The purchase price, not the modification, is the protection: the same exercise at a higher entry price is the subject of what a good ITV is for a non-performing note.
| Buyer yield at month 12 | IRR, bought at 50,000 | Bought at 60,000 | Bought at 70,000 |
|---|---|---|---|
| 9.0% | 82.8% | 63.3% | 47.0% |
| 10.5% | 70.2% | 50.8% | 34.6% |
| 12.0% | 58.8% | 39.6% | 23.5% |
One point of buyer yield at month 12 is worth 7,907 of exit price, between 9.5 and 10.5 per cent. That is why the exit yield deserves as much diligence as the entry price: the 10.5 per cent assumed here moves with rates and with how much seasoned paper is for sale.
The common mistake is to price the exit as a percentage of balance taken from a dealer's sheet, say 70 per cent, without checking what yield that implies on these particular payments. A note at 6.0 per cent with 348 months left and a note at 9 per cent with 120 months left can carry the same balance and be worth very different amounts. Price the payments, then express the answer as a percentage of balance, as in how to price a performing mortgage note for a target yield. The second mistake is to report the 50.8 per cent IRR as the deal's return; with any realistic re-default rate the expected figure is lower, 37.1 per cent at 30 per cent here.
Seasoning converts a modification into price: 24,919 of extra exit value from 12 on-time payments in this case. Model it as a yield curve against months of history, haircut it for re-default, and choose the exit month on IRR and profit together, not on profit alone. The book's Harlow Street modification and blend are in the free workbook for this book.
The length of the borrower's payment history since origination or modification. Buyers pay more for seasoned notes because re-default risk falls as on-time payments accumulate. In the illustrative case the buyer yield falls from 15.0 per cent with no history to 10.5 per cent after 12 payments, lifting the price from 66,383 to 91,301.
Long enough for the buyer yield to compress, but not so long that the IRR decays. In the illustrative case selling at 6 months earns the highest IRR, 59.0 per cent, but only 20,380; selling at 12 months earns a 50.8 per cent IRR and 38,014 of profit; waiting to 24 months earns more profit, 54,956, but only a 35.2 per cent IRR.
The investor is back to a workout. In the illustrative case a borrower who stops after six payments leads to a foreclosure recovering 82,000 net at month 24: still a 23,316 profit, because the note was bought at 40 per cent of the old balance. At a 30 per cent re-default probability the expected IRR is 37.1 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 1614 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.