Saturday, June 28, 2008

The New Sub-Prime

Private Money Lending is "The New Sub-Prime"

By Lance W. Newton

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 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"
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:

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:

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,,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

Copyright by Lance W. Newton. Republished by permission of Lance W. Newton.

The Next Edition of The Exeter Exchange Newsletter

The Next Edition of The Exeter Exchange Newsletter

The most current issue of The Exeter Exchange Newsletter (Volume II, Issue I) is now available for distribution in printed hardcopy and email PDF formats.

The Exeter Exchange Newsletter is written, produced and distributed by Exeter 1031 Exchange Services, LLC so that its clients and their professional advisors can stay up-to-date on 1031 exchanges and make better informed investment decisions.

You can get your copy of The Exeter Exchange Newsletter by calling any of our national branch offices or by downloading it from the Exeter 1031 website at

Volume II Issue I Topics Include

  • It's 3:00 in the morning...Will your QI pick up the telephone?
  • New standards for choosing a provider
  • Ten key questions to ask when choosing a Qualified Intermediary
  • In search of the exceptional Qualified Intermediary: Thinking outside the box
  • The beauty of personalized service: Is anyone home?

Thursday, June 26, 2008

Tax Deferred Exchange Reference Manual

Tax Deferred Exchange Reference Manual

There is an amazing amount of information circulating on the Internet today regarding tax-deferred exchanges. There are websites, blogs, PDFs, pamphlets, brochures, books, reference manuals and more about tax-deferred exchanges. There are also tax deferred exchange calendars, calculators, and widgets.

Tax Deferred Exchange Gray Areas Created By the IRS and Congress

The challenge with tax deferred exchanges is that there are many, many gray areas within the 1031 exchange process. The various tax codes, regulations, and rulings have made the tax deferred exchange very complicated and have also left numerous unanswered questions that tax deferred exchange industry experts must interpret.

This is why real estate investors will often find so many tax deferred exchange opinions, theories and facts that contradict each other time after time. Unfortunately, the tax deferred exchange gray areas will remain until the Internal Revenue Service or the courts issue tax deferred exchange rulings with more specific answers.

Tax Deferred Exchange Reference Book

We saw a specific need for a tax deferred exchange reference book that would help real estate investors identify and understand these gray areas and help explain the tax deferred exchange issues involved at a level that everyone could understand.

We did not want to provide the real estate investor with just "our opinion" or "our answer," but wanted to provide all sides to the tax deferred exchange issue in question so that the real estate investor could make a better educated real property investment decision.

So, the tax deferred exchange resource manual was born.

Wednesday, June 25, 2008

Fed Fund Interest Rate Remains Unchanged

Fed Leaves Short-Term Interest Rates The Same

The Federal Reserve Board voted today to leave the closely watched Fed Funds interest rates the same at 2.00%. This is the first time that the Federal Reserve has not lowered rates since the summer of 2007.

Federal Reserve Concerned Over Inflation

Concern was also expressed about inflation and inflation expectations by the Federal Reserve, but there was no hint of an imminent rise in the Fed Funds interest rates at this point in time.

Monday, June 23, 2008

1031 Exchange Workshop in Irvine, California

1031 Exchange Workshop

This is not just another 1031 exchange seminar. It's a 1031 exchange workshop where you can roll up your sleeves and learn about the requirements, structures, processes, strategies, and compliance issues necessary to successfully complete a 1031 exchange transaction.

Friday, June 20, 2008

The 1031 Exchange Institute Launched

There is a lot of information on the internet today regarding 1031 exchange transactions, but the majority of it is more sales and marketing in look and feel than educational and technical in nature.

We thought it was time to roll out a weblog that addressed the technical, educational, and resource demands of consumers today. So, we rolled out The 1031 Exchange Institute. Please visit the new weblog and let us know what we can do better so that it is more useful for you.

Thursday, June 19, 2008

How Can I Get An Extension For My 45 Day ID Period?

I hear this question virtually each and everyday. It's usually in a state of panic because the 1031 exchange investor is running out of time to identify his or her replacement property.

The 45 calendar day deadline to identify replacement property is a very short period of time and can be difficult, so 1031 exchange clients should start looking for replacement properties as soon as they know they are going to sell and structure a 1031 exchange.

Tax Deferred Exchange Due Dates Are Law; Not Regulations

Unfortunately, there is no way to get an extention of time for your 1031 exchange deadlines or due dates, unless you or the subject property is affected by a natural disaster such as a fire, flood, hurricane, etc.

The 1031 exchange deadlines or due dates are actually part of the tax code (laws) and are not part of the IRS Regulations (i.e. Section 1031 of the Internal Revenue Code), and can not be extended without an act of Congress. The IRS does not even have the ability to grant an extension, alter or postpone the 45 or 180 calendar day deadlines.

Monday, June 16, 2008

Beyond The 1031 Exchange: Cost Segregation Analysis

You've completed your 1031 exchange. You've deferred the payment of your income taxes. Now what?

Have you thought about doing a cost segregation analysis or study? It could provide you with significant income tax benefits in the form of higher depreciation write offs.

Cost Segregation Analysis

The general theory here is that you have acquired an interest in real property, but some of the real estate can actually be broken down into personal property components such as HVAC units, etc.

The cost segregation analysis does just that. A cost segregation provider studies the components of the building and then segments it into real property and personal property interests.

Increased Depreciation Benefits

Personal property has a much shorter life span, and as such, has a much shorter depreciation schedule. You can depreciate personal property much faster than you can real property and create more in income tax write offs to shelter more of your income.

Future Issues

The decision to complete this cost segregation analysis is not an easy one because the cost segregation analysis can also complicate matters later. For example, you have just completed a 1031 exchange and acquire "real estate." But, you then complete a cost segregation analysis and split it into real estate and personal property. Later you go to sell the property and the question is what are you selling? Is it real estate? Is it personal property? Is it both? Will the IRS allow you to have your cake and eat it too?

Financial and Tax Advisors

Always consult with your advisors before completing a cost segregation analysis to determine if the outcome is more beneficial than the long-term issues.

Monday, June 09, 2008

San Diego 1031 Exchange Workshop (Not a Standard Seminar)

It's Not Another 1031 Exchange Seminar, It's a Workshop

Join us for a 1031 exchange workshop (not a seminar) on the requirements, structures, processes, strategies, and compliance issues necessary to successfully complete a 1031 tax deferred exchange transaction. Continuing education credits available for Realtors (DRE), CPAs (CE) and CFPs (CE).

Reservations Required

You can visit for complete details and to RSVP. Reservations are required, and there are only three (3) spots left. You can also contact Suzanne Davis at (866) 393-8370.

We look forward to seeing you there.

Saturday, June 07, 2008

1031 Exchange and TIC Investment Property Seminar in Fresno, California

We are pleased to announce an educational workshop on the basics of 1031 exchanges and the use of tenant-in-common (TIC) investment properties as like-kind replacement property solutions for 1031 exchange transactions.

The 1031 exchange and TIC investment property seminar is scheduled for Friday, June 13, 2008 in Fresno, California from 11:30 AM to 2:00 PM.

You can RSVP via Email for this 1031 Exchange Seminar.

1031 Exchange and TIC Investment Property Seminar in Bakersfield, California

We are pleased to announce an educational workshop on the basics of 1031 exchanges and the use of tenant-in-common (TIC) investment properties as like-kind replacement property solutions for 1031 exchange transactions.

The 1031 exchange and TIC investment property seminar is scheduled for June 12, 2008 in Bakersfield, California from 6:30 PM to 9:00 PM.

You can RSVP via Email for this 1031 Exchange Seminar.

Monday, June 02, 2008

IRS Announces Disaster Relief for Various Storm Related Disasters

The Internal Revenue Service has recently issued a number of disaster relief rulings for various tornado and storm related damage. Here is a summary of the recent announcements with links to the various IRS news releases regarding each ruling.

Recent Tax Relief

Relief for Mississippi Storm and Tornado Victims see News Release
Relief for Iowa Storm and Tornado Victims see News Release
Relief for Georgia Storm, Flood Victims see News Release
Relief for Missouri Storm, Tornado Victums, see News Release
Relief for Colorado Storm, Tornado Victims, see News Release
Relief for Oklahoma Tornado, Flood Victims, see News Release
Relief for Maine Storm, Flood Victims, see News Release
Relief for Mississippi Storm, Flood Victims, see News Release
Relief for Arkansas storm, flooding victims, see News Release
Relief for Missouri storm victims, see News Release
Relief for Georgia storm, tornado victims, see News Release

Don't See What You're Looking For? Around the Nation contains links to previously issued disaster relief.

You can also contact Exeter 1031 Exchange Services, LLC should you need assistance in understanding what the rulings provide regarding your 1031 exchange transaction.

Sunday, June 01, 2008

Why and When Would You Consider a Reverse 1031 Exchange?

Significant Changes in the Investment Real Estate Market

The investment real estate market has changed quite a bit over the last few months, especially in the residential real estate market segment. And, the commercial real estate market is beginning to demonstrate signs of slowing and price adjustments, the real estate investor must review their strategy when it comes to investing in investment or income properties.

Total real estate inventory listed in the real estate industry today has increased dramatically because real estate is taking much, much longer to market and subsequently close. Buyers are having extremely difficult times in obtaining, qualifying for and funding new debt. Credit and capital markets are beginning to normalize, but there is still quite a ways to go before it is considered normal> There has also been a tremendous increase in foreclosure, deed-in-lieu of foreclosure and short sale transaction activity.

Complicates the Planning, Structuring and Coordination of 1031 Exchanges

Real estate markets like this make planning and structuring 1031 exchanges even more difficult for the investment property owner.

Reverse 1031 Exchanges

reverse 1031 exchange can put real estate investors back in the drivers seat of the real property transaction because he or she can take all the time they need to find the best and most suitable investment property and then acquire it first before the relinquished property has even been listed for sale.

The real estate investor then has 180 calendar days after they have found their new like-kind replacement property to market and sell their existing relinquished property. It is certainly a buyers market, but priced properly the property will move.

Increased Reverse 1031 Exchanges

We at The Exeter Learning Institute had expected to see a significant reduction in the number of reverse 1031 exchanges during 2008. The real property market would seem to favor selling first and then acquiring the like-kind replacement property via a forward 1031 exchange within the
1031 exchange deadlines.

However, we have been extremely pleases to actually see an increase in reverse 1031 exchanges due to the various problems within the credit, debt and capital markets. Buyers are facing difficult challenges in obtaining and qualifying for new debt and then closing on the relinquished properties and the real property owners are faced (forced) with the prospect of purchasing their replacement properties first or lose their investment property opportunity completely.

Reverse 1031 exchanges allow them to proceed with their replacement property purchase without losing their deposit, losing the income property opportunity, while still keeping the opportunity to defer the payment of their income taxes by using the reverse 1031 exchange.

Contact Information For Help

You can visit
Exeter Reverse 1031 Exchange Services, LLC's website for more detailed and in depth information on reverse exchanges.

Call Exeter 24/7

You can also
reach a senior executive of Exeter Reverse 1031 Exchange Services, LLC anytime you would like to speak to them - 24 hours a day, 7 days a week.