What if you were asked to design, from the ground up, the ideal investment?  What characteristics would your hypothetical investment have?

If you’re like many investors, and looking for something with income potential, non-correlation to the markets, deep-discount total return potential and high real asset collateral, you would probably want to make something like residential whole mortgage notes.

A mortgage note is a promissory note secured by a mortgage loan; it is written as a promise to repay a specific sum of money, plus interest, at a specified rate over an agreed-upon period of time.

Residential whole mortgage notes represent full ownership, for cash, of an underlying residential property. Lenders sell whole mortgage notes for cash, so that they can make additional mortgages, enabling them to earn money from origination fees, points and other closing costs.

Those who invest in whole mortgage notes are put in the same position as the lender. In a residential whole mortgage note, the mortgage pledges the underlying real estate as collateral. If a homeowner stops making mortgage payments and foreclosure is necessary, the investor will receive a share of the proceeds when the property is sold.

In addition, monthly mortgage payments are directed through the funding vehicle to individual investors.

While residential whole mortgage notes are a new asset class for investors, their origins are hundreds of years old. Under early English and U.S. law, a mortgage was treated as a complete transfer of title from the borrower to the lender, so the lender was entitled not only to payments of interest on the debt, but to rents and profits produced by the real estate. The real estate was of no value to the borrower until the debt was paid.

Up to the Great Depression, most mortgages were straight short-term mortgages, requiring payments of interest and lump-sum principal. When incomes dropped, many borrowers lost their homes. This foreclosure risk is somewhat tempered today, because mortgages from commercial lenders are fully amortized. Part of each payment applies first to interest and then to principal, with the balance reduced to zero at the end of the term.

Who benefits from residential whole mortgage notes? Everyone involved may, but for different reasons:
• Banks: The purchase of whole mortgage notes from banks and other lenders potentially benefits them by creating a liquidity event that can improve their balance sheets.

• Homeowners: Their loan may be restructured to their advantage, which may enable them to pay their mortgage and continue to live in their current home.

• Investors: In today’s market, whole mortgage notes can be purchased at deeply discounted prices. As the mortgage is paid off, investors can benefit from ongoing income, but they can also benefit from the “collateral gap” between the discounted purchase price of the mortgage and its full value when it is paid off.

• Financial advisors: Whole mortgage notes may be suitable as a substitute for an under-performing investment or to add diversification from an asset that is not correlated with either stocks or bonds.

Whole mortgage notes are bought and sold in the market every day. And, like other investments, they are affected by market forces. However, as asset-backed securities (ABS), they have a distinctive capital preservation feature: In the role of creditor, investors share an underlying ownership in the real property, whether it is sold or rented.

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