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.

Investors in whole mortgage notes are, in effect, the creditors for each note. Creditors are almost always made whole—no matter what happens to the debtor.

In contrast, when a corporation defaults on its bonds, the question becomes: “What am I left with if this security defaults?” With residential whole mortgage notes, the worst-case scenario is that you are left with the underlying properties.

That’s why, for many investors, asset-backed securities represent a more attractive alternative than investments in corporate debt.

Although a new asset class for investors, there are $2.5 trillion worth of residential whole mortgage notes available and plenty of lenders are willing to sell them at deep discounts—often in the 40% range. Sellers may range from the local credit union to large banks such as J.P. Morgan Chase, Citigroup and Wells Fargo. The largest banks are, of course, the biggest sellers.

Owning Real Assets
During tumultuous times, ownership of real assets becomes ever more important: This financial view is held by many of America’s leading pensions and endowments. Pensions and endowments have up to 50% of their portfolios in asset-backed securities, while the average investor may have as little as 5%.

Asset-backed securities enable depository institutions, finance companies and other corporations to raise cash by borrowing against assets. Assets such as credit cards, automobile loans and home equity loans are packaged as the collateral for intermediate-term securities and sold in public markets or as private placements. Other assets that have been securitized in this way include loans for mobile homes, pleasure boats and recreational vehicles—and residential whole mortgage notes.

Endowment managers and wealthy investors want to know, regardless of what happens in the market, that there is a hard asset behind their investments. This hard asset, whether it is gold, real estate or something else, is an indicator of the investment’s quality. An ABS can be collateralized by loans, leases, credit card debt, a company’s receivables, royalties and other assets.

Investments should also be viewed in the context of today’s economy. For more than five years, the Federal Reserve Board has been buying bonds through its quantitative easing program to keep interest rates low and help the housing market recover.

As the Fed unwinds its easing, interest rates are likely to rise and volatility is likely to increase. As the housing market and the broader economy improve, strategies for governments to exit these stimulus programs may renew short-term volatility.

To protect portfolios, it will become even more important for financial advisors and investors to diversify portfolios to withstand the potential shocks.

Financial advisor Gary Sherwold of G.W. Sherwold Associates says investments like residential whole mortgage notes could play the diversification role short-term U.S. government bonds occupied when interest rates were higher.

“The traditional non-correlation strategy of rebalancing a portfolio toward bonds during a cyclical equity downturn is not attractive with rates close to 0.0% in what many analysts say is the beginning of a rising rate environment,” he says. “[Asset-backed] strategies like whole mortgage note investments, on the other hand, give a portfolio a better chance at avoiding increased exposure to rising interest rates.”

Brian Gendreau, author of Cetera Financial Group’s 2013 Market Outlook, also sees residential whole mortgage notes as an alternative to bonds—especially given the improving housing market.

“If you can get a mortgage, then you can buy an appreciating asset,” he says. “Housing is going to continue to be a source of strength for the economy as a whole. … It’s a buyer’s market.  Residential whole mortgage notes are an attractive alternative to traditional bonds for today’s diversified portfolios.”

Given their non-correlation with stocks and bonds, income potential and other characteristics, whole mortgage residential notes can provide income and total return potential, regardless of how volatile the stock and bond markets become.

Gus Altuzarra is CEO and treasurer and Christopher Chase is president and secretary of the Vertical Fund Group (www.verticalus.com), which invests in whole mortgage notes. Altuzarra can be reached at [email protected]. Chase can be reached at [email protected].