John Philip Mason is a residential appraiser with 20 years experience and covers the Hudson Valley region of New York. He’s a good friend and a true professional who provides unique insight to appraisal issues of the day. Here is his weekly post called Solid Masonry. Jonathan Miller
Steve Bergman’s recent article in Barron’s, Distressful Opportunities, reveals a troubling trend in the lending industry. At a time when the real estate market has enjoyed some of the best years on record, it seems some lenders are looking to divest themselves of underperforming loans. While this makes perfect sense in declining markets with no upside potential on the horizon, it’s rather peculiar in the heat of such a strong market. Furthermore, when properties are over-leveraged or LTV’s (loan to value ratios) run close to 100%, lenders may be prudent in shedding themselves of bad loans with little chance of being repaid. But take a look at the following example cited by Bergman:
Gelt Financial, a small real-estate lender based in Southampton, Pa., recently bought the $190,000 mortgage on a five-unit Trenton, N.J., apartment building for $175,000. The property had an estimated value of $475,000, but the borrower was slow making payments and the lender decided it would prefer to sell the mortgage, rather than badger the owner, month after month.
The new note-holder offered the owner a deal: If he made regular payments for the 36 months and refinanced for 36 months, he would pay zero interest. What’s the catch? Gelt already had locked in a profit by buying the $190,000 note at about an 8% discount. And if the borrower, despite the easier terms, nonetheless defaulted, Gelt could take control of a property worth almost a half-million dollars.
In short, we have a lender discounting an asset 8% to facilitate its sale, with a 40% LTV and in a strong market! Now I don’t want to make it sound like the mortgage securities industry in about to collapse. As we all know foreclosures represent a small portion of the outstanding loans. But if this example is representative of even a fraction of the underperforming assets, then there should be alarms ringing in the halls of the Federal Reserve. For that matter, bells should be ringing throughout the land. Why? Well if commercial lenders are feeling in a bind with such favorable terms on their side; imagine their reaction when faced with terms which have become all too common on the residential side of the aisle. As buyers have been priced out of housing markets the lending industry has become more creative in offering loans with little or no money down, LTV’s approaching and even exceeding 100% and introductory “teaser” rates, while accepting borrowers with less than perfect credit scores, no income verification, and so forth. Sometimes these “exceptions” are done in concert with one another.
If residential lenders start dumping underperforming loans, hold on to your hats, for we have some high hurdles to clear in the next couple years. Especially if inventories continue to climb, energy costs remain defiantly high or changes to the tax laws turn unfavorable for homeowners and real estate investors. While real estate prices have always trended upwards in the long run, everything goes through cycles and it will be interesting to see how the lending industry reacts to the next downturn in the market. If lenders are bailing in a good market, then there could be trouble in paradise and sooner or later these chickens may come home to get roasted.