Keeping A Piece of the Action

Although debt paper can take many forms, ranging from mortgage notes to lottery winnings annuity contracts; we can usually describe the loan notes held by brokers and investors by placing them into one of two basic categories:

1) First lien notes that they can sell for a lump sum.

These notes have a beginning and an end, and when they are paid off, the note is canceled and no longer represents any debt.

2) Second lien notes that may be much smaller but offer the security of regular and gradual monthly installments of income.

These notes are created to take advantage of equity, for instance, and represent a new loan that will be paid off after the first lien has been satisfied. If someone owns a house with a first lien mortgage of $300,000 and they later borrow $15,000 against the value of their house in order to update a bathroom; the smaller note becomes the second lien.

By simply slicing up some of their debt paper pie, brokers can have their cake and eat it too, by creating a portfolio of diversified investments. Rather than putting all their eggs in one basket by only investing in first lien debt, they can rely on both short-term payments and longer-term payouts, by choosing to restructure some of their inventory of notes.

For example, if an investor wants to have a steady stream of income – maybe to plan for retirement or to help add principle to a college tuition savings account – the notes can be created with different maturation dates. By staggering the payments so that there are always some notes coming due while others are still “ripening”, the investor enjoys predictable monthly cash flow.

When the government advertises and sells treasury notes, the same idea is used to attract buyers. You can buy short-term notes of a year or less, and you can buy notes that don’t mature for many years. You might buy a long-term note to help finance a child’s education, and let the note sit for 15 or 20 years. A short note – say three years or less – might be more advantageous if you are planning to pull money out of the stock market temporarily and let it accumulate interest only until the next stock market upswing.

When a first lien note is sold, the seller gets paid and the lien is removed. As far as the seller is concerned, there is no more action to be had in that particular note and it is time to look for another investment. But if the seller creates a second lien on the note, the transaction becomes two-tiered. Even though the first note is paid off in full, the paper is still active because of the remaining second note. The entire note may be for $100,000, and the second lien is only for $10,000 – but several of these smaller notes taken together can represent a substantial investment portfolio, with a prudent level of built-in diversity.

Brokers who trade in debt paper often keep an inventory of various types of notes, so that they can tailor their investment packages to suit a client’s needs. And those who find themselves with mostly first lien notes can create smaller second liens, to automatically gain a diverse portfolio with twice as many options and opportunities.