From "Hard Money" to "Private Money" Lending, Using Pension Assets

What follows is a discussion explaining why I think “Private Money Lending” will become "The New Sub-Prime" resource for lending on many Single Family Residential (1-4 Unit SFR) loans in America and many other types of properties as well. The opportunity for you is to use money from Self Directed Retirement Plans, secured by real estate and other types of collateral. The returns from these “Private Money” loans will help you reach or exceed your retirement plan goals much faster, with control and real security.
 
Historically Private Money Lending (PML) was called "Hard Money" or sometimes "Equity Lending" or "Asset Based Lending" (ABL). Each loan was made based on a much lower "Loan to Value" (LTV) than "Conventional" loans from a Bank or Savings and Loan. Hard Money Loans have had a maximum LTV between 50 and 65% of the carefully appraised value on each property (the collateral for the loan). Hard Money meant 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. This is because the mindset of a Private Money Lender is conservative and capital preservation is a primary objective.
 
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. This is still true today and represents the major difference between a PML loan and a Sub-Prime loan based on highly leveraged, cheap money and impersonal computerized underwriting.
Historically, the rates, terms and conditions of "Hard Money" loans varied widely and there were abuses. In more recent years, legal 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 "Hard Money" Lending remained relatively expensive.
 
Another innovation in the middle 1980's was the creation of tools that enabled traditional "Hard Money" Lenders to pool their loans and thereby spread risk from a single property loan to a pool of loans. This change, in combination with regulation marks the transition of "Hard Money" Lenders into Private Money Lenders.
These "new" pools were similar to the pooled mortgages we read so much about today, but with major structural differences that make them a much stronger and more viable financing structure for borrowers and investors.  Another benefit of participation in a pool is the risk in any one loan being shared or spread with the other loans in a pool.

Keep in mind that for each loan in a Private Money Pool, the focus of underwriting is always on the strength of the collateral. An experienced lender thoroughly reviews the capacity of the borrower to repay and uses credit history primarily to price the loan. There is little or no leverage in this type of pool and a great deal of cushion for dramatic price changes since the LTV of any loan cannot exceed 65%. The insurance in this type of pool is the value in the properties, cushioned by the maximum LTV. The other cushion is the experience of the Underwriters for the pool. Even during the periods of the highest appreciation a PML underwriter is looking to preserve his capital and maximize his returns.

Most of us remember the Savings and Loan Crisis in the late '80's. That bailout cost U.S. taxpayers in the neighborhood of $320 Billion Dollars. 

At that time many loans were originated and held in the portfolios of regional and local Banks and Savings and Loans. In California and similar markets, a large component of that mess was due to thinly capitalized institutions that had originated and held more loans than they could effectively keep when prices went down.
Once the real estate market started to turn down bank regulators demanded that financial institutions mark down the value of the real estate assets collateralizing existing loans to their current market values. All but the strongest lenders could not survive the volume of failed loans that occurred as a result of "marking the loans to the market", because the loan balances outstanding were higher than the current value of many properties and there was not enough capital to cover the paper losses. The phrase "jingle mail" was invented to describe the phenomenon of more than 20,000 California homeowners who walked away from their loans and simply mailed their keys to the lender.

Securitization of loans, rather than holding loans in a portfolio, was the answer that Wall Street devised to avoid similar problems for the future and politicians who did not want another scandal or Federal bailout supported the new methodology.  (Which is what we got anyway in 2008, a $700 Billion bailout of supposedly infallible securitized loans.)
 
Asking loan servicers and trustees or the few remaining portfolio lenders to mark down the value of loan assets in the current market is not something that the regulators have requested.

The continued use of Qualified Special Purpose Entities (QPSE's) by financial institutions to isolate thinly traded mortgage backed securities and illiquid assets from hitting the corporate balance sheets (anyone remember Enron?) is probably not sustainable. Investment banks have scrambled to keep losses in portfolios from the light of day, using accounting practices reminiscent of Enron and there is pressure on the Federal Accounting Standards Board to eliminate the QPSE concept.  This will mean more losses and more fire sales of assets to shore up balance sheets at the affected financial institutions, regulated or not.

Current Market Issues

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 (some loans were written for 103% to even 125% of appraised value) on poorly underwritten loans in the pools. From day one, this has been a recipe for disaster. Because of leverage, there simply was never enough collateral or liquidity to reflect the real risk in many of these pools. At the extremes some structures using Credit Default Swaps (CDS) controlled 500 dollars or more of loan assets with less than one dollar of actual cash reserves.

Insurance in various forms was purchased to supplement cash reserves, but as we have seen in the news, the capital strength of the insurers is a concern to many.  When the Real Estate market turned down many mortgage pools controlled by servicers/trustees saw increased rates of default. Requests for loan originators to take back bad loans fell on deaf ears, since many originators declared bankruptcy due to excessive liabilities and poor capital. The financial geniuses that created the concepts and did the original calculations believed that the cash reserves and insurance/bonding safeguards were adequate and did not foresee the events that have happened.  As of June 2008, two of the largest publicly traded bond issuers have just $75Billion in deflating assets to back up about $1Trillion in Municipal and Corporate Bonds.  The "level 3" assets (hard to price, nearly impossible to sell) of 5 of the top Investment Banks on Wall Street (including assets of Bear Stearns) averaged 227.4% of capital and large banks and insurers are not far behind (Source: www.agorafinancial.com )
 
Because of the readily available loans in the emerging "Sub-Prime" market from 1990-2000, Private Money Lenders became "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 sell off loans to securitizers, 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 up-front fees and commissions for these loans represented huge short term profits for everyone involved. 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 and the availability of "Liar Loans" with LTV's that went as high as 103% of property values. The old timers saw the handwriting on the wall.

Supported by the artificially low interest rates that were in place, 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 develop long term experience by having survived multiple real estate cycles. For most, the lure of quick profits overcame common sense and prudent business practices.

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 ml-implode.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.

On top of the new bailouts for AIG and the rest of Wall Street, taxpayers are already on the hook for a 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 a valuation of 10-12 dollars would still be a bargain.
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?

We have seen the selective bailouts and nationalization of some companies with many more to follow.

Apparently the Federal bailouts will not extend to individual borrowers who either cynically manipulated the system in an out of control market or who were incapable of understanding the financial commitment they made to a lender.  Of course this will impact every borrower in between these extremes.  The ripple effect of these mortgages is very likely to affect properties and borrowers with good credit in the next 2 years.
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.

Another initiative that has passed into law is HR 3221, which will help some distressed homeowners with Adjustable Rate Mortgages.  A good article on this bill is at: http://www.wxyz.com/content/news/dwym/story.aspx?content_id=C75E9CAF-77C7-4000-B7F4-1A9B0D22D522&gsa=true

Meaningful Change will be Difficult and Painful

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 the losses related to them. Imagine if all of the $250 Billion of write downs related to Sub-Prime loans were taken by American financial institutions alone! Remember by several estimates there is another $750 billion of bad paper still to be written down. The so called "Secondary Market" for mortgage securities is all but closed for business and may never recover.
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: www.responsiblelending.org/issues/mortgage/research/subprime-spillover.html .
Estimating Long Term Costs

In a 2006 article published online by the Federal Reserve Bank of Chicago, GMAC-RFC, 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 hyper-sensitive 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 type of lawsuit 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 average investors 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 investment 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. We must also structure a system with much less leverage than we have seen in the past few years and regulate or dissolve the shadow banking system that has contributed so materially to this crisis.

For the foreseeable future, the opportunity is for private investors to begin aggressively funding Private Mortgage Lenders who underwrite their current loan pools and individual loans (or participations of multiple investors in “fractionalized notes”) based on low LTV's and the strength of the underlying collateral and with the use very 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. Of course this type of investment is illiquid by nature and suitable primarily for Qualified Fixed Income investors to diversify and find very attractive returns from monies allocated to longer term (5 year) investments.

Pooled investments typically require more complex, regulated legal structures and have a minimum investment of $25,000 or much more.  For investors with smaller amounts to invest, or pension monies to invest conservatively, small individual notes or participations in notes can be found with exceptional short term (as short as 60 days) returns.

 If you would like to share your thoughts or questions on this opportunity, Email me directly at lance@selfdirectioncentral.com.

Please note: The opinions expressed in this piece are not intended as either tax, investment or legal advice or opinions. The use of properly trained, licensed and insured professional tax, legal and other appropriate investment professionals to evaluate each investment you make is highly recommended.