This is a long post about “safety” in a tumultuous market, and about the unique opportunity we face as buyers of “distressed debt”.

And the premise I’m going to tackle is counter-intuitive, but very powerful. Do not underestimate the point I’m about to make. Acknowledge this, preach this, and you are bound to succeed. The evidence supporting the argument I make is all around you. You just have to see it for what it is: a blank check to back your non-performing note venture, big or small.

Hypothesis: a “Safe Harbor Fund” that invested purely in non-performing notes, is “safer” than any investment you can find on Wall Street or Main Street.

Interesting times. The common expression we share in the industry is to “keep your powder dry”, meaning make sure you have capital to play with because there are good days a’comin’. Even better than there are today.

A couple of observations, to put this into perspective (I’m going to show my true bearish colors here, and give you a peek into why my friends nickname me “Doomsday Dean”.)

A historic day – Treasury bumps our national debt over the $10T mark, the dollar will continue to weaken as fed tax rolls continue to soften.

Home prices dropped at a fast clip from June to July – dropping 1.1% across 10 key cities, according to S&P data (little clue on futures pricing here – min. of 1% decline in your collateral value each month, so if you’re estimating to hold for half a year, price in a 6% or greater value drop). Remember this number – it’ll come in handy again way down below.

WaMu and Wachovia will soon bring some large whole loan portfolios to the market, despite WaMu assuring us that they will begin to act as distressed debt investors and actively work their book. That will filter down to all levels of the 2ary market.

Large funds are being raised (Blackrock-$3B, Oaktree-$10B!, the list is long and growing) to buy whole loans as well as any three-lettered mortgage derivative that investment bankers swamped the markets with over the last 5 years.

The opportunity? It’s going to be a buyer’s market.

Listen to Paul over at HousingWire the other day: “Some sources, as a result, expected that the Treasury proposal could end up being a boon for distressed mortgages. ‘They’ll find out they need to churn and burn whatever they buy,’ one source suggested. ‘That could mean the market for whole loans will really start moving, with the pricing hurdles removed.’”

The key to remember is that there are 3 ways to win in this game: a) have cheaper capital than anyone else; b) have better operations than anyone else; c) flip the toxic assets quicker and better than anyone else.

These funds don’t necessarily have (a), and they certainly don’t have (b). That leaves (c).

So the chesspieces shift from the banks to the funds. So what? They’ll still sell. And chances are they won’t know what their assets are worth any better than the banks or their servicers did, they’ll just have a much lower basis.

See, the equation looked like:

Bank’s non-performing notes: bank would like to get 55% of face value.
Investor’s price offered for said notes: 40% of face value.
Selling price of notes: 55%.
Stuck. No trade.

And the equation now:

Bank’s non-performing notes: bank would like to get 55% of face value.
Investor’s price offered for said notes: 40% of face value.
Government’s bailout premium: 10%
Government’s bailout cost: tough-to-quantify-but-these-warrants-don’t-make-sense-and-Treasury-isn’t-moving-fast-enough-and-these-private-funds-don’t-ask-half-as-many-questions
Bank’s decision: 50% chance of selling to Investor, 50% chance of selling to Government

If Bank sells to Investor at 40%
Investor can resell for 50% and make a 25% rate of return (ROI, not IRR)
Selling price of notes to you and me: 50%.
Trades galore.

Investor can resell for 45% and make a 12.5% rate of return (ROI, not IRR)
Selling price of notes to you and me: 45%.
Trades all over the place.

So you and I should be backing both the Republicans AND the Democrats on the Hill right now. The Republican monkey-wrenchers are actually trying to lob in insurance premiums that would guarantee to push sellers into the private markets. And the Democrats are all about convertible warrants, executive pay and the like, also pushing sellers into the private markets.

Either way, there will be tons of notes going around. Today’s volumes will be dwarfed by comparison.

Take your savings out of your risky bank institutions and stick them under the mattress. Don’t be tempted by FDIC bumping up insurance to $250K. You’re still going to get sub 4% yields on your money (my favorite is ING Direct – offering 4.50% on 24-month CD’s right now. Get it while it lasts).

So, given comparable savings rates, why not pay par for a non-performing 1st mortgage if you can get it at a 50% LTV? As long as it’s accruing at a better than 4% rate, what do you care? As long as you feel the house value’s not going to drop in half (doubtful anywhere in the country, even by Doomsday Dean standards), you’re still ahead of the game in terms of your bond/index/equity or CD returns.

Oh, and instead of relying on some government institution like the FDIC (only $45B left in the kitty, and that’s with “only” 13 institutions that have failed – there will be plenty more – and Sheila Bair, FDIC Chairman admitted last month that she might have to tap into Treasury for short-term borrowing needs) to insure your funds, you can have a fully insured (force fire insurance on the property you’re lending on and charge it to the borrower) and safely interest-bearing loan.

One of the logical plays in this market would be to raise a “Safe Harbor Fund”. Acquisition parameters: any non-performing notes at a max 45% LTV on current value, minimum note rate of 8.5%. Almost doesn’t matter what the discount is on UPB. I’d just focus on being a contrarian – paying up to 90% on ANY note that is at a 50% LTV on value. Everyone would hit your bid.

Raise capital at 7% (the key, of course) from everyone who’s terrified of the next bank failure. Marketing this puppy is the genius that I leave to those of you with the brains, chutzpah and creative flair.

But the concept is – compare risks from investing in almost every “safe” instrument out there …
-Treasuries (listen to the gnawing and growing fear of a US default on its debt – never hit $10T before, and last time I checked, fed revenues were down across the board – at every level of national, state and municipal government in this country, budgets are tight, losing their balance and losing steam as unemployment continues to drive lowering sales tax and income tax revenues, and boosts unemployment and other social spending expenses)
-Money markets (bust-the-buck Reserve Money Market fund, anyone?)
-Auction rate securities (Goldman and UBS) – “safe as cash!”
-Bank savings accounts (hello Indymac)
-your mattress (nah, your neighbor will eventually find out)

… and compare those “potential” risks (noone really knows what the “actual” risk is) to holding a non-performing note.

What do you care if the borrower pays or not? Eventually you can reclaim the house. And as long as the value doesn’t drop far enough to threaten your investment (at a 45% LTV, even Doomsday-boy is fine with that), your investment accrues, and isn’t going anywhere. Assuming that rate of a 1% drop per month that I mentioned at the beginning of this post – that would mean that you’d start “risking” your investment in about 55 months, or just under 6 years. Obviously that’s where the magic and fortune-telling come into this business. Not even the bear of the bears Nouriel Roubini himself is predicting a further 50% drop in values, however. You have to get somewhat “real” here.

A little story.

One of my investors emailed me a few days ago and said: “Dean, give me some counsel …. I’m maxed out against the FDIC insurance limit of $100,000 across a number of accounts. What should I do?” Well, he opened up EIGHT new accounts just to get the $100K insurance coverage as many different ways as he could, and he still had several few million that he wanted “protected”.

I told him about the Safe Harbor Fund, and his words were: “It’s a hell of a lot better than whatever unknown risk I run at Fremont Bank.”

Risk is “uncertainty”.

Almost across the board, most financial institutions face an “uncertain” future because of the “risk” of their mortgage and lending portfolios getting worse than they already are.

Buying “uncertain” assets – e.g. non-performing mortgages – takes out almost all that risk.

What the heck am I talking about?!

Well, look at it this way. The real reason banks aren’t lending to one another, and why inter-bank lending rates are so high right now, is that noone really knows whether their counterparty (the guys asking to borrow money from them) will be around tomorrow to pay them back on the loan.

Well when I’m buying non-performing notes, guess what? I have ABSOLUTELY NO UNCERTAINTY about whether my borrower’s going to pay me back on my “loan” to them. It’s a 100% default risk. Therefore there’s no uncertainty about that.

The only “uncertainty” when you’re buying non-performing notes is whether the house (collateral) will continue to support the value of your investment (e.g. will it be worth more than what you paid for the note, therefore making a worst-case scenario of my having to take over the property to pay back my loan, still allow me to come out ahead of the game).

Conclusion: a Safe Harbor Fund investing purely in non-performing notes, is “safer” than any investment you can find on Wall Street or Main Street.

You choose.

Whether you agree or not doesn’t really matter. What matters is that you look at what the “risk” and the “uncertainty” is in investing in non-performing notes, and compare that to the risks and uncertainties of practically every other instrument out there.

The less you think about this as a real estate investment play, and more as a survive-and-thrive-in-this-market-chaos play, and tell all your friends and relatives and colleagues and neighbors about it, the more you will succeed in raising capital to be a player in what is – and will continue – to be an historic and momentous time to be investing in distressed debt.

If you are ready to get serious about Buying Notes, check out my 16-hour+ ‘A-Z Profiting from Discounted Mortgages Business-in-a-Box’ Course.