In Seller Financed Real Estate Notes, What Else?
by Ruth Hauser
(Editor’s comment: We have been saying for quite awhile that when interest rates go down there is less seller financing and things get a little slower for us. And as interest rates rise our business gets better and there will be and are more notes for us to go after as the interest rates go up. Instead of just taking our word for it, Ruth Houser did some research that explains the reasons behind why and how this happens. If you haven’t noticed an increase in your own personal volume yet, get ready.)
If you were to take a moment and read the major news sources and listen to what the Federal Reserve Chairman is saying, you will see that there are significant changes occurring in the subprime lending industry. Floundering sub prime lenders are huge indicators that the inventory of seller financed notes is soon to grow exponentially. We see seller financing demand dramatically increase when conventional mortgages –including Alt-A and sub prime lenders—are hard to get. Being part of a niche within the finance and real estate industries, current events don’t often affect our business, however, it is obvious that note buyers will be enjoying an increase in the inventory of seller financed loans. Go to this link and read for yourself what is happening.
Defaults on sub-prime mortgages have risen to close to 10%; on Alt-A, they are standing at just 2% – but that’s double the default rate of 12 months ago. David Liu at UBS expects that eventually 1 in 20 of the two million Alt-A mortgages issued last year will default.” In an article written by John Stepek, www.Moneyweek.com in March ‘07: “The bad news for the wider economy – which the Fed likes to say is going to be just fine – is that it looks like it’s not just the sub-prime borrowers that are defaulting. It seems that the sub-prime mortgage rot is spreading. Defaults on ‘Alt-A’ mortgages, which stand between prime and sub-prime loans, are also rising. According to The Times, the value of ‘Alt-A’ mortgages issued last year was $400 billion – that compares to just $85 billion in 2003. That was about 16% of new mortgages issued that year; the sub-prime market comprised 25%. (Emphasis added)
First, the demand for home financing will still be there, it does not go away!
Second, as the conventional sources of funding dry up, what you will see is that seller financing will be used more and more by investors and others to market and sell their properties. The end result is that with the increased use of seller financing, there will be a larger inventory of notes to be purchased. How significant are these changes? Here is an excerpt from the State of the Note Industry address given by Eddie Speed last year:
“Nothing has been more significant to fuel the growth of our industry in the last several years than this. ‘Seller-financing fills the void when conventional lending doesn’t’”
Third, when you follow the money, it looks like the funding free for all for subprime lenders has been stopped in its tracks as Wall St and big banks tighten their requirements and provisions for subprime lender loans. Even conventional lenders will be looking closer at their lending requirements.
This is a windfall for us as note buyers and brokers.
As subprime lenders tighten their qualifications and in some cases, go out of business by increased federal disclosures and stringent contracts to sell their loans to Wall Street, the only market left is the seller financier. The increase in inventory of available loans should be huge with a corresponding demand by note holders to become note sellers. With the decreased presence of the subprime lenders, we will be seeing longer term notes that will not be cashed out in a few years by refinancing. Ask any of the major note buyers about the lower than normal inventory levels of eligible notes in recent years as everybody and their dog could get a mortgage!
With the increase in demand for seller financing, we will be seeing less of the extremely high risk borrowers. Why? Seller financing is typically a fixed rate mortgage as opposed to the teaser or step rates promoted by the sub prime industry, where buyers are lured into and “qualified” for lower initial payments. Will seller financing fall into the same slippery slope as the sub prime lenders? Probably not given that the sub prime lenders spent billions on marketing to everybody with ridiculous rates for an initial period and they were more concerned about their commission checks than verifying the intent of the borrower—meaning that sub prime lenders believed the applicant when they said they were going to occupy the home. Investors quickly realized that no one was checking and they fraudulently applied for “first home loans, second home loans” and so on. Typically, when seller financing is created, there is a higher level of scrutiny regarding the borrower occupying the home and a greater reluctance or refusal to offer financing for an investor.
Another positive aspect to the decrease in availability in sub prime lending is that seller financed loans will enjoy a longer existence as cheap refinancing ceases to become a viable alternative to new home buyers and investors. We can build portfolios of notes for wealth building as opposed to constant replenishment of scarce seller financed loans as experienced in the recent past. Reducing the churn in our market helps to stabilize our business and reduce costs associated with obtaining loans while we can enjoy the fruits of retaining loans!
If you wonder why the subprime lending market enjoyed such a long run of success with funding sources, the reason is that when the banks and brokerages provided funding to subprime lenders, they typically came with a buyback guarantee requiring subprime lenders to repurchase a loan if the borrower defaults in the first few months. There are a number of borrowers who are defaulting in the first few months and the lenders have to repurchase these loans from the banks, or in some cases default on their repayments. What fueled this funding?
In recent years, investors looking for high yields with investments backed by real estate eagerly bought bonds for their portfolios as the stock market lagged. The mortgage backed bond business has been a major profit center for these banks and brokerages. That is why there was so much news about the exposure of banks like Barclays and Wall Street firms when some of the top 25 subprime lenders sought Chapter 11 bankruptcy protection as you saw in the above link.
The subprime lenders earned big profits through fees and points, but also by reselling their loans to Wall Street firms like Merrill Lynch and Lehman Bros., who then packaged them as bond offerings to individuals and institutional investors.
Ruth Houser is President of Blue Horse Investment Group, LLC in Florida and a subscriber, note broker and note buyer for many years. She invites your questions and comments and can be emailed at RuthHouser@BlueHorseNotes.com