As I write this in the spring of 2007, the real estate market is in the throes of yet another of its recurrent downward cycles. Consequently, a frequent question we get these days is: “How is the latest meltdown in the subprime lending industry affecting the purchase of owner-financed paper?”
This is merely a twist to the more typical “down market” question: “How is the latest meltdown in the LENDING industry affecting the purchase of owner-financed paper?”
The short answer . . .
The short answer is essentially the same: “The same as it does whenever tight-money cycles occur in the conventional lending markets. More sellers and real estate agents fall back on using seller-carryback financing as a means for achieving the sale of a property.”
This time around, the conventional lending industry is not in a meltdown (at least not yet); however, the current “down market” cycle has some unusual factors in play–made worse by the collapse of the subprime lending industry.
In fact, though the real estate market continued gaining momentum from 1995 through 2005, twice over the past seven years, both Wall Street and Main Street have been enamored with riding the “Paper Tiger” of subprime lending–with disastrous results!
While other factors are certainly playing in the current down draft, for real estate and note investors, real estate agents and note brokers/finders understanding several salient nuances (historical and otherwise) of the subprime lending markets, can go a long way in exploring sensible ways to profit in this current “down market” cycle.
No more roar!
Subprime mortgage lending only came into mainstream usage roughly fifteen years ago. Based on the unsound business model of making high LTV loans to poor-credit, high-risk borrowers, this “Paper Tiger” lending industry niche was almost wiped out in a massive collapse in 2000/2001 when poor credit borrowers with limited equity “surprisingly” began defaulting on their loans! Imagine that?
Then promoters made it even worse, by developing new subprime loan products that use unrealistic repayment terms that ultimately result in the very dilemma we are seeing in the housing market now. Just as in 2000/2001, the subprime lending market has imploded–this time contributing its troubles to the current real estate market malaise.
Though subprime loans only make up roughly 12.5% of the residential real estate lending market, they have accounted for 60% of the current foreclosures that are exacerbating the price decline in the single-family residential market, according to the nonprofit Center for Responsible Lending. This trend has held steady through the first quarter of 2007.
Tiger butter
So how did subprime lending, a market that only came into the mainstream roughly fifteen years ago, ever get a foothold? Because Wall Street investment bankers and the lenders who packaged subprime paper convinced both investors and borrowers that this subprime lending model somehow made sense!
Why did these Wall Street types and mortgage-lending folks do that? Because they saw an opportunity to make big fat fees by funneling investor money into subprime lending vehicles and creating loan products that essentially led to malady “chronic loan addiction.”
Consider the differences between prime conventional loans and subprime loans to substandard borrowers, some of which we have pointed out over the years in CRE Online’s Cash Flow Forum.
The trap
Subprime lenders typically generate loan origination fees anywhere from FOUR points to SIX points and occasionally as much as TEN points, charged against the gross loan amount. Compare that to loans to good credit borrowers, where typical loan origination fees run from 1.5 to 2.5 points. (*A point equals one percent.)
This doesn’t include any “back-end rebates” a lender may earn from the pricing spread when bundling the loans in Collateralized Mortgage Backed Securities for Wall Street.
Subprime loans often don’t include escrow accounts (reserves for property taxes and insurance), so the monthly payments look more affordable to the borrowers, but more insidiously, so borrowers may be trapped into coming back in two or three years for another round of expensive borrowing, refinancing the loan in order to pay back taxes.
Also, most subprime loan products contain stiff prepayment penalties, in states that allow it, forcing a subprime borrower to pay fees equal to six months interest on the outstanding balance if the loan is paid off any time before two years (in some states) and five years (in other states).
These prepayment penalties apply, even if refinancing through the same lender, to pay off the prior subprime loan the borrower originated through that lender!
The most insidious device has been the “loan reset” trap, whereby subprime borrowers are lured by low initial rates that often jump to exorbitant higher rates in two to three years, leaving the property owners to either “Refi” or “Repo-out.”
Any and/or all of these factors worked to essentially force subprime borrowers to keep the subprime lending mill churning, making subprime lenders FAT, while everybody else began choking on their own blood. Now, while both the investors and the borrowers try to climb out of the holes they fell into, those who packaged and sold the loans are laughing all the way to the bank.
Just one of the companies profiled–and perhaps the biggest–not only resuscitated itself from virtual collapse in 2001, but also reportedly went on to make its three primary principals roughly $40 million in profits from the sale of its stock shares over the past few years. Meanwhile, the company itself tanked, taking down the shareholders, the holders of the MBS, and the borrowers.
Lenders got fat and got out
Investors in the shares of these companies, as well as those investing in mortgage-backed securities that the subprime lenders sold to Wall Street, are left holding the bag–a bag full of bird cage liner!
The borrowers are left with broken dreams and broken families. And the remaining owners of residential real estate are taking a pounding, too, as mounting foreclosures contribute to longer marketing times and declining prices.
The most immediate effect subprime lending had over these past few years was contributing substantially to the “bubble” effect in many parts of the country by providing a deeper pool of buyers. These buyers, in turn, helped fuel and sustain the ever-rising price of residential properties throughout many parts of the country.
Unfortunately, this upward-rising price trend was artificial. Certainly, the demand was there, but far too many under-qualified home buyers used subprime loans to purchase “more house” than they could afford!
Consequently, substandard borrowers (along with preconstruction flippers) added further pressure on the demand side of the housing equation, driving home prices upward and creating a false market.
The consequences
The consequences have been essentially the same as a pyramid scheme. In the short term, this was good for people who desperately wanted to own their own homes. But over time as their budgets became strained, people already living on the edge fell off the cliff.
In the short term, rising prices were good for home sellers–at least in getting a great price for their existing homes. However, not so good if they had to turn around and purchase another home at inflated prices.
And in the short term, it was great for real estate agents. They were able to work less to earn more. Now, they face difficult selling conditions–and a limited buyer pool–as the pool of repeat customers they would have had were vaporized by the very subprime loans they used to purchase their homes in the first place.
A high number of fraudulent note sales, including an inordinately high volume of fraudulent “simultaneously closed” notes contributed mightily to the eventual demise of several of the most prominent institutional note buyers.
Perhaps a bigger factor was the simple fact that institutional note buyers did not have the luxury of charging the stiff “borrower fees” enjoyed by subprime lenders; nor back-end rebates paid by investors; nor “recycling” borrowers over and over for additional fees.
So what does all this have to do with seller-carryback purchase-money financing? Nothing! Or everything, depending on your point of view and your determination to profit during the current downward spiraling marketplace. Watch for Riding the “Paper” Tiger: Profit in Today’s Marketplace , coming soon.