February 2008
Vol 31 No 5
A few weeks ago, Judge Christopher S. Boyko, of the U.S. District Court in Cleveland, Ohio opened a can of worms that won’t soon be closed. He threw out 14 foreclosure suits that mortgage investor, Deutche Bank, had filed. He ruled that a security backed by a mortgage is not a mortgage itself; thus, because Deutche Bank could not produce a chain of assignments of the debt to itself to prove that it was the holder of the defaulted mortgages; it had no legal standing before the court. Unless overturned by the Supreme Court, or remedied by Congress, this far reaching ruling has the potential to shake up the trillion $ plus secondary home mortgage market, and ultimately, change the ways houses will be bought and sold.
When John Q. Citizen sells a mortgage to a mortgage investor, he records an Assignment of all his right, title, and interest in the Mortgage (or Deed of Trust) and conveys the original of the assigned Note to the investor who is buying the debt. When payment on the Note is defaulted, it’s easy for the court to track the ownership of the debt, and for the foreclosing party to provide legally sufficient evidence of the ownership of the Note. But transfers of debt are very different when large institutional investors get into the act. Here’s why:
For decades the securities market has provided the bulk of mortgage funding. Here’s how: Your friendly local banker doesn’t have enough money to support all the house loans he can make, so he sells his loans into the secondary market and earns a servicing fee that runs about .5% of each payment. When combined servicing portfolios add up to trillions of dollars, these fees can be impressive.
Who has enough money to buy trillion of dollars in home loans? Nobody! Fannie Mae and Freddy Mac, both quasi-governmental agencies, buy millions of home loans from banks all over the country. These are assembled into $100,000,000 bundles that are sliced and diced into slivers. Each sliver contains parts of many loans. Certificates representing these slivers are sold to investors who, in turn, re-package them and sell them to others. You can see why lenders have trouble producing the original Note when a home loan is paid off. Bear in mind that these Certificates are merely Mortgage-backed securities rather than the Notes themselves. The problems is that legally, only the holder of the original Note can foreclose.
When investors buy these share Certificates, the money is recycled into the mortgage market to buy more loans from banks. Banks in turn loan the funds to new borrowers to buy homes. In 1981 there were $367 billion of these securities outstanding. By 2007, there were $6.5 trillion of them in the secondary mortgage market. Without mortgage backed securities, the housing expansion of the past few decades could not have existed. Can you imagine how few houses would have been sold if banks had only been able to lend the funds they had on deposit or could borrow? I couldn’t have survived as a Broker, Landlord, Speculator, or short term lender.
Whether you know it or not, your home loan could be indirectly owned by many investors including Pension Funds that provide retirement funding; Insurance Companies that hold debt against future claims, Hedge Funds that sell mortgage-backed shares to customers, foreign banks that want to diversify, and individuals who buy securities backed by these bundles of debt.
The Ohio ruling poses potential problems for not only for institutional lenders, but also for just about everybody who takes title “subject to loans”, or who do Short Sales, or who buy discounted loans via assignments from lenders who rely upon Title Insurance to protect their interests. The big question is not whether this problem can be fixed, but how, and how soon, and at what cost in this election year when politicians are busy running for re-election.
ONLY THE TIP OF THE ICEBERG . . .
Problems in the mortgage markets have a resounding effect on the real estate industry, and for the country at large. The whole sub-prime fiasco was a direct result of the availability of easy credit supplied by the securities markets.
When most people think of investment it’s in terms of the stock market rather than the home loan market. They don’t realize that the mortgage based real estate market is much more important to the health of the American economy. When you subtract mortgage-backed securities, the home mortgage market dwarfs the Stock and Bond markets. Anytime that trillions of dollars are being loaned and the debt is being sold off, you can bet that a lot of middlemen and businesses are sharing this money.
When you consider all the jobs in the construction, labor, financial, manufacturing, transportation, and securities industries; many millions of jobs and many billions of dollars are at stake. Politically, Congress can’t allow the mortgage industry to collapse, but resolving the issue is going to have to balance the rights of lenders, borrowers, home-owners, and investors; all of whom can bring considerable political pressure on politicians, both national and international.
Because of the Sub-Prime melt-down and growing numbers of loan defaults, confidence in the stability and security of mortgages and mortgage portfolios has been shaken at home and abroad. The disease is spreading; there has already been a run by frantic depositors on an English bank that invested too much money in high-yielding sub-prime American loans. Now a German bank has been denied its suit to foreclose defaulted loans. Everyone’s ox is being gored. Some of America’s largest money-center banks are being forced to write down billions of dollars in loan losses, and hedge funds are under extreme pressure. State, County, and City employees’, Teachers’ and Union retirement plans are largely invested either in mortgage backed securities, or in the shares of companies that invest in them.
This has only scratched the surface thus far. What about borrowers and entrepreneurs who need mortgage financing? What about people being foreclosed now?
If a lender can’t prove that it has a mortgage interest in a house or can’t produce a promissory Note, why would anybody continue to make payments? Lawyers will be swift to exploit the Ohio ruling when looking for a way to avoid foreclosures. Already, in Ohio, a suit has been filed to reverse a foreclosure sale. What does a foreclosing lender without a Note or Assignment do when a suit is filed? It could be forced to audit all loan payments and to show how they have been timely credited toward the amount owed? If a judge can stop a foreclosure, couldn’t the same judge require a foreclosing lender to return all payments until it could prove it was entitled to receive them? How much could this cost a foreclosing lender? How many lenders would elect to foreclose rather than to work out a refinancing scheme?
What’s the true value of any company when its net worth is based upon assets comprised of mortgage loans, mortgage-backed securities, or loan guarantees? How many Hedge Funds are in violation of SEC laws? How many retirement plans are under-funded today? What effect will this have on the stock value of financial companies? How does a lender value its loan portfolio when it may not be able to collect its debts? What institutional investor is going to buy shares in a loan portfolio when it has no standing in court? What effect will the Due-On-Sale clause have on existing house sales when a lender can’t enforce it? How does anybody know?
Those who have paid off mortgage loans have seen the loan balance claimed by the lender routinely to be more than the loan balance calculated by the payor over the life of the loan. Now, the entire series of loan payments can be challenged. In the one case that I personally monitored, the foreclosing lender had overstated the loan balance by over $100,000. It quickly settled. What about houses being sold on Installment Contracts under which the seller is obligated to pay off underlying loans and deliver the property free and clear at some point in the future; how does he know he’s paying off the right loan in the right amount? Ditto for wrap around loans and all inclusive Deeds of Trust?
POLITICAL SOLUTIONS DON’T WORK VERY WELL OR VERY LONG.
People often ignore that there is supposed to be a balance of power between the three branches of government. The original framers of the U.S. Constitution didn’t completely trust government of the people, by the people, and for the people; nor should we. They rightly understood that when a few people hold power, it is soon used against those who don’t have any; so they divided up things in a sort of scissors, rock, and paper governmental game where the President is the Rock, the Supreme Court is the Scissors, and the Congress is the paper. Here’s how it’s supposed to work:
The President isn’t supposed to pass laws, create money via the FED, or wage wars not approved by Congress. When he does, Congress can refuse to budget the money to enforce them. The Congress can pass laws that the President can Veto or refuse to sign. When this happens, he can override them. When Congress and President run amok, the Supreme Court can strike down any law that it deems unconstitutional. While the President and Congress have to run for election, the Supreme Court doesn’t; but Justices must be nominated by the President and approved by Congress to get their jobs. This system is supposed to be more or less mirrored in State and lower governments.
Even casual observers of the political process have seen that the system doesn’t work as well as it was designed to work as each branch of government starts to encroach on the others. Most of the wars since WWII were started without prior approval of Congress. For decades, Supreme Court Justice appointments have been based less upon merit and proven ability of nominated Judges than upon political viewpoint and input from special interest groups. (i.e. Reagan’s appointee, Robert Bork) Congress legislates according to which wind is blowing the hardest; and despite the fact that Congress is supposed to represent the citizenry, special interest groups with their millions of dollars are able to blow a lot harder than voters. Politicians who ignore lobbyists soon find themselves out of work.
It’s against this background that government has started putting patches on the mortgage market to lessen the effects of the sub-prime meltdown. The FED has cut bankers some slack so that they can carry defaulted loans longer prior to foreclosing them, thereby shoring up their balance sheets so they look stronger than they are. The IRS has given a free ride to all those speculators who bet the farm on continued rising home prices by refinancing and home equity loans. The taxes they ordinarily would have had to pay on total debt in excess of their tax basis will be forgiven. They’ll ultimately be rewarded by taxes levied against prudent homeowners who didn’t treat their houses as ATM machines.
FEMA is a prime example of what happens when government bureaucrats try to solve big problems. Bear in mind that the home mortgage market is many billion times larger than the entire Katrina problem. Government agencies that step in to manipulate this market will probably create an even bigger mess. Those who were around during the Resolution Trust Corporation debacle may recall the efficiency with which the government tried to resolve that loan crisis. They managed to waste half a trillion of the taxpayers' dollars while destroying the S&L industry.
Now, the President wants to freeze indexed loan terms for five years for a favored few despite the fact that this boils down to governmental interference in the Constitutional rights of the citizens to enter into contracts. The courts will surely weigh in on all of this when those who invested in promised loan yields that fell far below those bargained for file lawsuits against the lenders and Brokers who sold them. With all the manipulation and fraud that has already taken place, and uncertainty thereby created in the mortgage market, the government might well be the only investor willing to buy loans and keep the mortgage market alive.
We can’t really predict what will happen as a result of the Ohio ruling, but we can begin to plan our own responses while keeping a wary eye cocked in the direction of Washington, D.C. and be prepared to act once we see what happens.
MACRO PROBLEMS CAN CREATE OPPORTUNITY FOR MICRO OPERATORS
Entrepreneurs have a big advantage over large institutions. They can adapt and adjust to radical market changes much faster. While institutional lenders dither awaiting a political solution, we can continue to find ways to make money. Put things into perspective; we don’t create shares in our Notes for sale all over the world. We’ve already started adapting to the shortage of conventional investor loans by buying and selling homes using seller financing. In last month’s letter I mentioned creating a sale using seller-financing, and then selling the Note and Deed of Trust at a discount to a private mortgage investor to raise cash. An entire industry sprang up to fund discounted Notes at the time of the last credit crunch.
Competition is the enemy of profit, thus profit flows to those who have a monopoly in the market. A.T.&T held a monopoly for a century on telephones. The oil companies hold a joint monopoly on gasoline. The medical, banking, and brokerage communities use licensing to limit competition. When you learn to buy, sell, manage, finance, and fix houses in new ways, you create your own monopoly based upon skill and talent. The changing mortgage market creates this opportunity.
Traders Clubs are starting up in some markets. Those with property, money, or mortgage Notes get together to find ways to make deals by swapping the properties they have. My friend Peter Fortunato and I were both listed in Who’s Who of Creative Real Estate because of our problem-solving skills and creative financing solutions. The title of a course we created to teach others how to do this was “Transactioneering”. In it we dissected each potential house purchase or sale to find the elements that could be used to make a deal. These included the way title was held, the price range, occupancy, the amount of existing mortgage debt, and its payment terms, whether or not the property was leased, the tax problems of the parties, various legal entities, and the time frames of the parties. Attendees at our December seminars at sea have had a taste of how we use creative techniques to make deals. In response to demand from this group, we plan to present a joint creative problem solving seminar in July in Reno in order to pass on some of the tricks of the trade that we learned to create when lenders refused to make us loans.
When institutions are unable to make mortgage loans because they may not be able to sell them into the secondary market, that leaves the field wide open to those who lend, or buy and sell mortgage Notes at discount. Here’s one way that Pete Fortunato was manufacturing high yields when I first met him: He offered to pay 50% of the loan balance on performing mortgage Notes with no more than 70% loan to appraised equity. As an inducement, Pete gave the seller a future right to buy the Notes back at the same price paid for them. 99% of them bought back the loans.
This was a good deal for the Note seller, but a better deal for Peter. The seller was thus able to raise needed cash only at the cost of missed payments. What did Peter get: Suppose he paid $50,000 for a 9% loan with a balance of $100,000 and payments of $804.62 per month. Until the Note was repurchased, he would earn $9655.47 per annum on his $50,000 investment; that’s an annual yield of 19.3%. How could you take either side of this transaction and make a profit? If not on the high yield of the discounted paper, you could use cash raised by selling “paper” to Option houses builders’ inventory and build equity as the market returns to normal.
Those who use cash to buy leveraged Options from discouraged sellers in today’s falling markets will earn fantastic deals within a couple of years with very little risk. By structuring seller financial arrangements in your Option, you’ll be able to avoid the need for hard to get institutional loans; thus be able to continue to make money with houses when most of today’s competitors have faded away. If you don’t know how to do these things, what are you going to do about it? In the February Options seminar, I’ll show you how to use Options with both paper and houses so that you can not only survive, but also to thrive in today’s market.
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