Notes on Notes – Part 2
While participating in a panel discussion recently at Quest Expo in Houston, Texas, I was asked a wide-open question regarding the varieties of mortgage notes out there. (If you read my previous post, you will recall that I am using the term “mortgage notes” to relate to those secured by real estate via a mortgage or deed of trust.) As any lawyer would do when asked a wide-open question, I gave a very long, broad answer and discussed the difference between firsts and seconds, performing and defaulted, and a hybrid called a reperforming note. Let’s briefly walk through these five types of notes.
- First-Position Note. This type of note is in a senior position to any other liens on the property except for real estate taxes. It is a voluntary lien, meaning the owner of the property signed the appropriate paperwork consenting to have that lien placed on their property. This is commonly done when you borrow money from a lender or bank when buying or seller-financing a property.
- Second-Position Note. A note in a second or junior position means there is another note that has priority over it. In the event a forced liquidation of the property occurs, such as a foreclosure, any taxes, costs of the foreclosure and the note in first position would be paid first, and any money left would go toward paying the lienholder in second position. I have seen situations in which there have been notes secured in third, fourth, and even fifth positions, particularly on the west coast with how Californians can structure debt on property.
- Performing Note. The borrower is paying as agreed according to the terms of the note and security instrument such as the mortgage or deed of trust.
- Defaulted Note. Also called a nonperforming note, it means the borrower, for one reason or another, is not making their payments as agreed. Obviously, the value of a defaulted note is very different from that of a performing note.
- Reperforming Note. This hybrid is a note in which money was lent, the borrower made payments and then stopped, but they are now making payments again according to some type of modification or forbearance agreement which allows the borrower to catch up on their obligation.
There is a market for each of these types of notes among investors who have varying degrees of appetite and risk taking for such paper-based assets. The foregoing is obviously a very broad generalization. Each type of note has its own unique characteristics and attributes, which is why the essential skill of reading and understanding the paperwork is so important.