Private Money Lending is "The New Sub-Prime"
By Lance W. Newton
lance@thenewsubprime.com
What follows is a discussion explaining why I think Private Money Lending will become "The New Sub-Prime" for single family residential mortgages in America.
Some History
Historically Private Money Lending was called "Hard Money" or sometimes "Equity Lending". Each loan was made based on a much lower "Loan to Value" (LTV) than "Conventional" loans from a Bank or Savings and Loan. Private Money Loans had a maximum LTV between 50 and 65% of appraised value on each property (the collateral for the loan) and higher fees and interest rates than the loans available to more "credit worthy" borrowers. The pricing of these loans reflected the risk to the lender and often included a risk premium.
Since the real security for each of these loans is in the underlying property value, if the borrower could or would not make the payments, the lender had to come back to the property to recover his investment. The rates, terms and conditions of these types of loans varied widely and there were abuses. In more recent years, limitations were placed on the practices of this type of lender that limited fees and rates within a narrower range. Federal Regulations were implemented, but Private Money Lending remained relatively expensive.
Another innovation in the late 1980's was the creation of tools that enabled Private Money Lenders to pool their loans and thereby spread risk from a single property loan to the pool. These pools are similar to the pooled mortgages we read so much about today, but with major structural differences that will keep them strong and viable for the future. Keep in mind that in a Private Money Pool, the lender thoroughly reviews the capacity of the borrower to repay and the focus of underwriting is on the strength of the collateral!
The failure of so many securitized Sub-Prime Pools in the current market is a result of too much leverage and very high LTV's on poorly underwritten loans in the pools. From day one, this has been a recipe for disaster. There simply was never enough collateral or liquidity to reflect the real risk in many of these pools. When the cycle turned they could not survive the volume of failed loans that occurred. The financial geniuses that created the concepts did the calculations did not foresee the events that have happened.
Because of readily available "Sub-Prime" loans in the marketplace from 1990-2000, Private Money Lenders became to an extent, "lenders of last resort" and the business contracted but did not disappear. Some changed their business model and originated and sold loans just like everyone else. In large part, this was because of the increased use of underwriting standards based on credit scores and mathematical models and the pooling of mortgages with different risk characteristics into securities, theoretically eliminating the risk from Sub-Prime and lower rated borrowers.
Once the system was in place for originators to easily and readily sell off loans to firms that bundled them into securities, the historical checks and balances in mortgage lending (like verification of employment and assets) began to fail, in part because there was minimal risk retained by the originators (or so it was believed) and because the upfront fees and commissions for these loans represented huge short term profits for everyone involved. Mortgage brokers in particular have taken much of the blame for “Agency” issues and once again, there were visible abuses to point at.
Good Private money lenders kept the best performing loans they originated for themselves to the limits of their capital, but they could not compete (and did not want to compete) with a market place awash in capital. The availability of "Liar Loans" with LTV's that went as high as 103% of property values were greeted with scorn and the old timers saw the inevitable collapse as handwriting on the wall.
Supported by the artificially low interest rates that were in place for years, the Boom real estate market expanded and originations of more and more exotic, highly leveraged mortgage instruments increased. Even Private Money Lenders felt the pressure created by the overall easy money environment and many increased the LTV's offered on their loans from historically safe levels of 50-65% to 70% or above, or expanded their offerings to include equity lines at high rates. Many of these lenders have failed or will fail and many were companies that did not have the benefit of long term experience by having survived multiple real estate cycles.
For most, the lure of quick profits overcame common sense and prudent business practices. Going forward it will make even more sense to do business with well known and accomplished survivors.
Fundamentals, like a meaningful correlation between income and the cost of properties were abandoned as the market expanded and prices ballooned. Everything was great until the system reached a tipping point in 2005-2006. As Bennet Sedacca of Atlantic Advisors has said "Debt must be serviced, repaid or refinanced or go into default".
Ignoring the facts has never changed the facts, so here we are today...
The Sub-Prime Market has Turned Full Circle
Who has not heard daily about the Sub-Prime mortgage meltdown? We are bombarded with daily updates on which mortgage company has now closed and which large bank, brokerage house or insurance company is announcing losses of double or triple initial estimates on investments in Sub-Prime mortgages. There is a popular website at www.mlimplode.com that has tracked the failures of more than 256 lenders since late 2006. Some of these lenders were huge.
Many large individual investors in seemingly safe financial institutions have lost their shirt on stocks held for investment or investments in mortgage related securities. A few have profited enormously from the declines of these securities. A top hedge fund manager for a fund betting against various Sub-Prime instruments made a heady $3.7 Billion in personal compensation for 2007. His top fund returned over 500% to individual investors (after costs) for the year. Many hedge funds holding the same securities for the long term lost everything or went bankrupt before losing everything. Several large pension funds held long term positions in the mortgage securities that went down. Only time will show the effects of those losses to pensioners.
The Federal Government has gone to previously unheard of lengths to prevent further damage to the finance/mortgage industry and the interlocked dealings between Wall Street, the Mega Bankers and mortgage originators of every stripe, including opening the discount window to investment banks.
Taxpayers are already on the hook for the Federal $39 Billion dollar, non-recourse loan made to secure the purchase of Bear Stearns at an initial price of $2 per share. Since the stock traded for $30 per share the Friday before the bailout/purchase on the following Monday, this may well represent the deal of the century for the buyers.
Bear Stearns was at the heart of an intricate web of cross collateralized and highly leveraged exotic mortgage instruments whose failures could have collapsed our financial system. If $39 Billion were the true ultimate cost of this bailout, it would be cheap. Now of course, every investment banker that profited from the run up of the bubble sees the Fed (translation=Taxpayers) as the low cost financial solution to a decade of previous highly leveraged financial excess. Why act responsibly when there is no downside, little chance of prosecution for misdeeds and a federal bailout around the corner?
Apparently the Federal bailouts will not extend to individual borrowers who either cynically manipulated an out of control market or who were incapable of understanding the financial commitment they made to a lender and every borrower in between these extremes.
Current political initiatives (like the S 2636 Foreclosure Prevention Act) to help borrowers with Adjustable Rate Mortgages (ARM’s) or Option ARM’s, are a political football and consumer advocates like the "Center for Responsible Lending" are supporting legislation to help a broader cross section of borrowers than earlier anemic initiatives (see the article "Earlier Subprime Rescue Falters" online.wsj.com/public/article/SB120285480915463431.html?mod=yahoo_free). Any such legislation will be gutted before passing or be vetoed by the current administration.
The deep pockets of the financial industry, their lobbyists and the politicians that are beholden to their financial industry patrons, would seem to make meaningful legislation in this area all but impossible. Too much money has been made by too many people for too long with no consequences for any misdeeds and incredible payouts to insiders.
If you listen to talk radio on the topic of borrower bailouts you hear the outraged cries of former mortgage brokers and real estate industry insiders who do not want any kind of bailout for borrowers, in particular the unqualified speculators that abused "Liar Loans" to flip properties and boost the bubble in real estate prices. These callers seem to overlook their own contributions, in league with appraisers and lenders and brokers that contributed greatly to the bubble. I keep thinking of a quote from author Sinclair Lewis who said something like "It’s hard to get a man to understand something when his salary depends on his not understanding it".
These same outraged callers are also forgetting the interlocking relationships between speculators and regular homeowners who qualified for the best financing and put 10% or more down on their properties. If a "free market" approach had been allowed to take place, a real estate crash would have undoubtedly occurred on a scale hard to imagine.
Americans are also incredibly lucky that foreign investors bought so much of our mortgage securities and have sustained the losses related to them. Imagine if all of the $250 Billion of write downs related to Sub-Prime loans (so far) were taken by American financial institutions alone!
Remember that by several estimates there is another $750 billion of bad paper till to be written down. The so called "Secondary Market" for mortgage securities is all but closed for business and may never recover. The ripple effect is already impacting the commercial loan market as well.
As disgusting and one sided (in favor of the financial industry) as the current bailouts seem for many people, they have slowed down the overall rate of foreclosures and may prove to be a brilliant solution to the crisis. Of course history has proven that any market cycle that is artificially extended on the upside, experiences a longer and harsher downturn and resolution on the downside. This market cycle is not immune to history, just different in form.
While there is no doubt that responsible borrowers and savers are adversely affected by the actions of the irresponsible, most Americans simply do not realize the enormity of the problem. A good discussion of the potential mayhem for equity values and eroding tax bases is at: http://www.responsiblelending.org/issues/mortgage/research/subprimespillover.html.
Estimating Long Term Costs
In a 2006 article published online by the Federal Reserve Bank of Chicago, GMACRFC, Americas largest private issuer of mortgage backed securities and a leading warehouse lender, estimated that it loses $50,000 per foreclosed home (a cost that would likely accelerate in a rapid downturn). The entire article can be viewed at: www.chicagofed.org/community_development/files/02_2006_foreclosure_alt.pdf.
The system in place today has created a bias toward foreclosure as the path of least resistance for a servicer or trustee, because of the contractual limitations/difficulties and potential liabilities related to any attempt at modifying terms on any loan in almost any securitized structure. (Email me if you want to read my article on this topic).
The percentage of successful loan modifications is very small as is the percentage of successful short sales by borrowers in trouble. We will see if market conditions force lenders to modify more loans or accept more short sales, but right now foreclosure is the easiest option. There is little doubt that too many foreclosures will force financial institutions to change tactics as many are very thinly capitalized and they do not want to take back properties on a mass scale.
A possible wild card would be mandatory federal guidelines for handling problem loans, but financial institutions are likely to fight the tough measures necessary to resolve the problems mass foreclosures would create and politicians in an election year are hypersensitive to Governmental solutions that would be overtly recognized by voters as taxpayer funded.
Of course for individual borrowers making legal claims against originators that have failed or are in bankruptcy there is little hope of legal remedy and it is likely that their house will be long gone before a class action might produce results.
Everyone needs to realize that the well we all drink from has been thoroughly poisoned. Just how far the poison will spread is the real issue, not whether thousands or even hundreds of thousands of small speculators will be bailed out of ARM type loans and into federally subsidized, fixed rate loans.
Most of these speculators who have not already walked away will be ruined financially even if they are able to negotiate temporary modifications directly with their lender, or if there are more Federal programs to convert their loans from variable to fixed rate loans. Since most paid a speculative premium, the fundamentals are not there to sustain a long term investment.
If the underlying values have dropped sufficiently, these investors are likely to keep only those properties that cash flow enough to make sense as an investment. Just about everyone in America knows that in most areas, speculation on Single Family Residential properties is dead for the foreseeable future.
We are definitely back to basic "buy and hold" fundamental strategies for the average small investor or more bulk purchases for the wealthy like the recent sale of 11,000 new homes in 8 states from a national home builder to various hedge funds at 40 cents on the dollar.
Americans also need to understand the longer term social costs to every taxpayer when borrowers in inner city and lower income neighborhoods who were deceived in this Sub-Prime mess lose their homes as a consequence of the deception. This is due both to the ripple effects on surrounding homes and the long term social costs to the nation in the affected neighborhoods. All borrowers would be well served by a rational and logical bailout of this sector as near term direct costs will be far less than any well structured alternative.
Out of Disaster, a new Opportunity
If you haven't seen the opportunity yet, let me spell it out for you.
It will take years for all of the systemic problems we are seeing to be resolved. In the meantime, existing or new mechanisms must expand to fill the void. It is hard to say how large financial institutions will respond in the future and if securitized structures will be redesigned for sustainability in the mass marketplace. Perhaps the deep thinkers in other countries affected by the same issues, like England, Ireland, France, Germany or Australia will come up with a viable structure, while financial institutions here continue to resist the inevitable changes to an unsustainable system. The demand for loans is still out there and originators can process loans all day and night, but if the loans cannot be sold into a secondary market place, this system is finished as currently structured.
For the foreseeable future, the opportunity is for private investors to begin aggressively funding the Private Mortgage Lenders who underwrite their current loan pools based on low LTV's and the strength of the underlying collateral and with little or no leverage. The low LTV's provide downside protection for investors along with the additional collateral that is often used to secure these loans.
Experienced managers of these types of pools will be able to demonstrate a track
record of limited losses to investors. with excellent potential returns that are secured by realistic valuations of the underlying assets and plenty of liquidity to handle foreclosures in the portfolio.
Of course this type of investment is illiquid by nature and suitable primarily for Qualified Fixed Income investors who need to diversify and find reasonable, secure returns from monies allocated to longer term (5 year) investments.
The Future
Perhaps in the longer run, new methods to meet the basic needs of modern society for mortgage financing will be created. Robert Shiller, the Yale Professor of Economics who helped established the Case-Shiller Home Price Indices now run by Standard & Poors, http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/2,3,4,0,0,0,0,0,0,0,0,0,0,0,0,0.html, has advocated a concept he calls the Continuous Workout Mortgage”. To paraphrase him, this concept would include a mortgage that is “privately issued so that the cost would be priced into the rate. And they would be mortgages that are flexible in the sense that the payout scheme responds to changing economic conditions and changing ability to pay."
We will need to wait and see how the market reacts as future economic conditions unfold. If you wish to share your thoughts and comments, email me at lance@thenewsubprime.com.
Copyright by Lance W. Newton. Republished by permission of Lance W. Newton.
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