April 1986
Vol 9 No 6
The three little pigs used to sing that song. They continued to sing it right up to the time that the wolf huffed and puffed and blew their house down. There's a moral in that story. There's another moral in Aesop's fable about the boy who cried WOLF. While Disney made the point that one should heed the warnings of impending danger or prepare to suffer the consequences, Aesop counseled his readers of the hazards of warning others of imaginary dangers lest they become blase. In both instances the warnings didn't achieve the desired defensive response from the listeners, and they consequently paid a penalty.
As the writer of an investment letter, I've got to thread that thin line between issuing too many proclamations of doom (the Aesop error) and too few. My challenge then is to keep my readers informed as to the pitfalls lurking along their path so they'll be able to take adequate precautions, and at the same time, to motivate them to perceive the opportunities that abound. While I wouldn't want to dismiss the effects of the new tax bill, foreign trade and budget deficits and the speculative rise in the stock markets in my planning, I think the condition of the credit and banking industries is one of the most critical factors which will affect your future activities as single family landlords and investors for the remainder of this decade.
Supposedly Americans are enjoying the mature stage of one of the better recoveries in this century. Employment is up. The stock market has doubled in price in the past 4 years according to the Dow Jones averages. Long term interest rates are comparable to those in late 1978 for mortgage loans. The housing affordability index shows that the median house is within reach of the median family income and existing house resales topped 3.5 million in 1985. At the same time, rents in many areas continue to rise. Landlords are beginning to win a few in the courts. What could possibly go wrong? Housing has an Achilles Heel. It's CREDIT! Unfortunately, credit and banking are inextricably intertwined. That's what's going wrong. Hence, both your savings and your future income could be in jeopardy.
WE'RE TURNING INTO A NATION OF 'MONEY JUNKYS'.
Forget about national statistics. How dependent are YOU on availability of credit? Would you be able to buy any houses if you had to pay all cash? Would builders be able to build? Land developers to develope? Salesmen be able to earn sales commissions? Lenders be able to lend? And suppose you worked in an allied industry – what effect would a real credit crunch have on furniture and appliance sales, the lumber, cement, copper, carpet, glass industries? Insurance? New home construction is what makes these related business activities prosper. When there's no credit, business dries up. So does employement. So do rents. Just at a time when government expenses for welfare and social costs start to increase, tax revenues start to decline. That's when there's truly no substitute for CASH.
Americans are unique in the Western world. We're saving a smaller percentage of our incomes than citizens of other civilized nations, so we're far more vulnerable to periods when jobs and credit dry up. That's especially true of those who've over extended their finances buying investment property which carries low or negative cash flows. Even more serious is the plight of our corporations. They're carrying more debt as a percentage of their assets than ever before. Like leveraged 'nothing-down' real estate investors, they can achieve spectacular results so long as things are going up. But they'll drop like falling stars if sales slump. That means they'll be dependent upon banks to carry them
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over the rough spots. Or they'll fail. And their stock prices will tumble, taking all those leveraged speculators down with them. It's easy to forget that it takes buyers to stop a market slide. In a down turn, who's going to be able or willing to buy? Who'll have the money? Who'll supply the credit? The banks? Read on.
THE CRACKS ARE APPEARING IN THE DAM . . .
Someone once said that Americans are dancing on the decks of the Titanic. So long as the music plays, who's worried about icebergs? Tampa Bay is one of the hot spots singled out by John Naisbitt in 'Megatrends' as one of the winners in the demographic foot race over the rest of this century. Yet we've had two major bank failures in the past 4 years. The Metropolitan Bank in 1982. Park Bank last month. It was the 6th largest bank failure in FDIC's history. It hardly caused a murmer. FDIC stepped in and within 3 days had sold it to Chase Manhattan. They opened for business and have already solicited me to open an account there. They're offering initial depositors the highest interest rates in the area. Why become concerned? Not one depositor lost anything out of his insured savings account up to $100,000. Chase Manhattan is a good company, right? Who's hurt?
Let's dissect this event to see what happened. First, Park Bank made a lot of real estate loans to marginal people on iffy projects. They too expected inflation to conceal a lot of errors in judgement. They charged high interest because they had to pay high interest to attract depositors' funds – kinda like Chase Manhattan is doing. Carrying costs caused lots of these loans to go bad. On February 14th, the State Comptroller declared the bank insolvent and notified FDIC. FDIC began an immediate audit while, at the same time, they solicited bids from other banks to take over Park's operations. Chase Manhattan was selected and the Circuit Court approved it's offer and sale. 3 days after the failure, Chase held a press conference announcing the purchase. They paid $62.6 million for administrative costs, $40 million in new capital and took over $378.5 million of Park's assets leaving FDIC with the more questionable loans which totalled $214 million.
Think back to the last distress sale you attended. If we round off some of the zeroes we might relate it to a house transaction. How many times have you ever seen a house loan which went into default, was foreclosed, re-sold, and re-rented in 3 days? How often would a lender (You don't suppose Chase used its own money do you?) be able to fund an acquisition loan to enable you to buy it? How much luck would you have in getting a quick loan to buy a foreclosed house with negative cash flow when you'd had a history of poor investments, losses, highly leveraged speculations and low net worth? Yet Chase was selected as the winning bidder to take over a bank in the lucrative Florida market which had been denied to them and to other New York banks by the supreme court.
There's been a persistent belief in hard money circles that smaller banks are going to be sacrificed to the larger banks who will then be kept solvent by government policy at tax payer's expense. The above circumstances might not make a case, but look at what else Chase Manhattan has been doing along the same lines. Chase bought 3 failing S & Ls in Maryland and 6 in Ohio. Bear in mind that Chase Manhattan has BILLIONS in bad loans in Mexico, Brazil, Venezuela, Argentina which EXCEED its net worth by several times. According to Business Week, it's also high on the list of banks with non-performing assets. A non-performing asset is a loan without payments property with no income. Odd.
BUT THERE'S MORE . . . BANKS CONTINUE TO FAIL AT A RECORD PACE IN THIS RECOVERY . . .
120 failed in 1985. 13 more have already failed in 1986. With energy prices nose diving, energy belt lenders and those with foreign loans to oil exporting countries are in dire straits. Financial shock waves are felt throughout the banking community when banks or thrifts fail because banks lay off loans in the same way bookies lay off bets. The disease can spread rapidly until it grows to epidemic proportions. FDIC can't handle the load if all the banks on its problem list fail. FSLIC is in worse shape. Wall Street Journal reports that 465 S&Ls are operating insolvently. No one will bail them out. Over $14 BILLION in deposits are at stake. 70 S&Ls went broke and were shut down in 1985!
How does one pick a bank that will remain solvent? VERIBANC, INC., P.O. BOX 2963, Woburn, MA 01888 provides a service which rates banks as to their financial strength. Merely using an insured savings account may not be sufficient. FSLIC only has about 3.2 billion dollars to protect the $14 billion currently in jeopardy with another 2.8 billion in reserve. 800 additional troubled S&Ls may join the insolvent ones soon. Think about it this way – would you want to insure your car or home with an insurance company which had a mere fraction of the financial reserves which would be required to insure your claims? Command Productions, Custom House POB 2223, San Francisco, CA 94126 reports an average of 1 bank failure occurs every 5 days in America. They publish a booklet called 'SAFE BANKS'. It costs $29 post paid and lists 2400 strong banks. Plus they'll include a report on your present bank in that price. Why take a chance with your cash reserves?
DESPERATE CIRCUMSTANCES GIVE BIRTH TO DESPERATE MEASURES – GOODBYE TO RISK-FREE LOANS . . .
HUD has finally awakened to some of the scams involving FHA loans. Faked credit reports, faked occupancy, faked appraisals, faked documentation, TV 'come-ons' describing ways to circumvent FHA regulations and standards. An investigative task force is looking into abuses in 15 cities. The acting chief of the FHA has been quoted as saying: 'If you've ripped off the government, you won't be given a second chance.' HUD is beginning to place a lot of emphasis on collecting delinquent loans. IRS is being notified to withold refunds on federal taxes when the tax payer owes the government money.
Over at FNMA, things are also getting ugly. They've got 8000 single family houses too many that they've foreclosed. A recent communique to the servicers of FNMA loans has directed that: 'Only as a last resort should we use foreclosure'. They go on to direct that the servicer exercise FORBEARANCE. My dictionary defines that as patience. Next, they suggest a WAIVER OF THE DUE-ON-SALE CLAUSE! Currently only 5 states still enjoy a window period on their non-assumable loans. These are: Arizona, Michigan, Minnesota, New Mexico, and Utah. Readers in those states should contact their lenders for more data. In other areas, FNMA seems ready to dicker whenever they're vulnerable to more foreclosures.
Fannie Mae Servicing Guide, Section 502.04, Item C authorizes FNMA loan servicing offices to accept a LESSOR AMOUNT IN FULL SATISFACTION OF A LOAN. They can also MODIFY THE TERMS by reducing the interest RATE, extending the term of payment, changing from a fixed-rate loan to an ARM or vice-versa. FNMA's guidelines don't make this a licence to steal. They've got to feel that their flexibility will place them into a better position and make loan repayment more secure. And lenders who allow loans to be assumed or modified will be held responsible. On the other hand, they've instructed their servicing agents to extract their pound of flesh anytime they have to foreclose. First, they'll try to assist a distressed borrower to re-sell the property IF the next buyer is more credit worthy. If they're sent a Deed in lieu of foreclosure, they'll send it back unless there's no hope of receiving payment. No longer will it be sufficient just to decide you don't want the property. FNMA wants a look at your financial assets. If you have any, they'll proceed to foreclose. They'll make a minimum bid at the sale and seek deficiency judgements where they can. They'll allow distressed owners to pay a cash award for the privilege of avoiding foreclosure if it will be more profitable. And they'll notify the IRS to look into the tax returns to be certain that the person who surrenders the property is taxed as to any 'mortage over basis' that might exist. In short, it's never been more important to avoid liability and marginal properties.
MOVE AND COUNTER MOVES CONTINUE . . .
If they hand you lemons, make lemonade! You say you want to get into distress buying? You say you want to pick up bargains wholesale? Tell you what I'm gonna do: I'm gonna put you into the hottest little number in town – a VULTURE FUND. That's what they call the new syndications who specialize in buying up larger properties or portfolios of properties at super distress prices only to restructure the financing and to sell at a profit. These can be mutual funds, limited partnerships, joint ventures. Some of the big boys are taking a close look at the yields which the current distressed markets in the oil belt are offering. In Houston recently the VA auctioned off 250 houses. They went for a fraction of their loans at prices ranging from $21,000 to $88,000. Let's look at an average price of $40,000 and assume that these could be disposed of over the next two or three years at $60,000. net after sale costs. 20,000 dollars times 250 equals $5 million profit. That's just scratching the surface. The real bargain sales are just beginning.
So how does one get to be a quantity buyer? By joining with others. Thus, that's where Vulture Funds originated. Lincoln Property Corp., Unicorp American Corp., JMB Realty Corp. and VMS Realty are considering them. Bear, Sterns & Co. are rounding up capital. Amurcon Corp, a Michigan developer is starting one up. It takes a lot of financial muscle to buy and hold, awaiting a market turn around. But there's little doubt that somewhere, sometime, those who buy right and hold long will reap fortunes. Keep your eyes peeled for these opportunities in your area. Those starting the funds are aiming them directly at the small investor in much the same way that mutual funds raise funds to control large blocks of stock.
When FDIC takes over a bank's assets, first they try to sell off as much as they can to the bank who buys in. Next they liquidate as much as possible in public sales. I've attended a few. The prices are terrific, especially for office furniture and small items. On larger items, they show little imagination except where cash is involved, then they'll listen to wholesale proposals. They'll also sell off batches of loans at discount. There have been several auctions of 2nd and 3rd mortgages and trust deeds which have sold at deep discount because of their underlying fragility. Here again is a place where those with nerves of steel and hearts of ice can make a substantial profit – IF they guess right.
With each failure, the surviving lenders become more cautious. This means that investors – especially leveraged real estate investors – are going to have a tougher time refinancing, pulling cash out in loans, 'bending' the FHA or HUD regulations, getting high appraisals, and getting loans for speculative ventures. That's the bad news. The good news is that houses with good assumable loans will command premium prices and rents as the supply of mortgage funds and new housing shrinks. And there will be bargains galore to be had from FNMA, VA, HUD, FDIC and FSLIC as they too become distressed sellers.
We live in a volatile economy. Even without any financial emergencies, we only have a few more months in which to restructure bad loans and the situation is becoming urgent. HUD has issued regulations which severly restrict investor – or investor related parties – financing of single family houses. Computer searches are being initiated on a national basis to identify those who assume large numbers of HUD loans, or who engage in deceptive practices with respect to such loans. They'll be watched closely on any future financing. HUD mortgagee letter 86-5 lists many of the subterfuges being taught as ways to circumvent FHA investor financing limitations. Some of them have become federal crimes. It might behoove you to obtain this from your local HUD office and review it.
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