Seller Financing – Good and Bad

I love everything about banks but I realize I might hold a minority view on that one. Maybe you don’t like banks as much as I do. If so, this one’s for you.

Today is about seller-financing, which is a way to cut out banks from a traditional bank function.

Seller-financing happens when:

  1. Traditional banks can’t or won’t lend money to facilitate the sale of something expensive. Usually, but not always, real estate.
  2. The buyer doesn’t have enough cash to buy the thing outright and needs to make installment payments, and
  3. The seller doesn’t mind being paid in installments, including interest, over time.

Traditional banks have their comfort zone for lending. Situations that fall outside of their comfort zone become eligible for seller-financing. Typically there’s something non-standard about the property or the buyer or the situation that makes a bank loan impossible. Or sometimes, more simply, buyer and seller don’t prefer to use a bank for some reason, so they agree to structure up a loan directly from the seller to the buyer.

I sat down for lunch recently with Bill and Alison Mencarow of Kerrville, Texas, publishers of The Paper Source newsletter, which is the single most important source of wisdom and advice on creating, buying, and selling seller-financed notes.

paper_sourceI’ve been an off-again, on-again subscriber to their newsletter for a dozen years now, but to my chagrin had never met them in person, despite the fact that they live just a short ride up the road from me.

I don’t necessarily recommend you get involved as a buyer, seller, or investor in seller-financed notes. Because, well, read on. But if you DO ever decide to get involved, you have to subscribe to their newsletter.

Anyway, I used to invest in this business, as a purchaser of secondary seller-financed notes, bought at less than face value. When all went well, as a buyer I would collect regular interest and principal payments. If the note payer refinanced or sold their property I would get paid off early, and I would make an even higher return than the stated interest rate on the note because of the discount at which I bought the note. It can be, and was at times, a lucrative business.

I prefer to write about finance topics for which I have some expertise. What’s an expert, you ask? I define an expert as someone who has lost money doing that financial activity. By that definition, I am a clear expert in seller financing.

What I like best about the Mencarow’s newsletter is that while they support investors in the seller-financed notes business, one of their main themes is how things can go wrong. Like, really wrong.

In my old investment days, I purchased seller-financed residential mortgages, seller-financed commercial mortgages, and seller-financed business notes. In the creation of these seller-financed notes, almost by definition, something non-standard is going on.

Maybe the buyer has weak or non-existent credit and the traditional bank turned them down for a loan. Maybe the buyer did not have a sufficient down payment for a bank loan. Maybe the property needed a ton of renovation, so could not get appraised near the selling price. Or maybe, similar to the “all-cash” theme I wrote about last week, the participants in the transaction prefer to avoid banks so that their financial activity remains “invisible” to financial authorities. Any one of these scenarios increases the risks for the person collecting installment payments over time.

I’ve also been on the other side of the transaction, offering installment credit to a buyer so that I could unload a property more quickly. I used this technique to sell a 4-unit commercial property in upstate New York that needed renovation. Two separate buyers defaulted on the notes, one after the other, and twice the property came back in my possession. In each case the property returned in worse condition than before. All the copper wiring got stripped out of the property one of those times, as it turned out my buyer had a, let’s say, familiarity with folks who knew how get a good price for scrap metal. Seller-financing to him did not lead to a happy result for me.

no_bank_neededI’ve also had numerous experiences of people ceasing to pay on their notes. Sometimes they pay a bit late, and then a little bit later still, and then the payments just stop coming. I’ve spent more time than I care to admit writing letters, sending emails, making phone calls. Sure, I’ve hired lawyers to enforce on the notes too. Sometimes this works and sometimes you end up taking a big loss.

The Mencarow’s newsletter serves as a guide to common mistakes in buying and enforcing payments on notes, including fraud, as well as the many ways investors can get way over their head or underwater through seller-financing.

Experiencing this a few times partly explains why I appreciate banks a lot.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle

 

 

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Dueling Mortgage Gurus and Uncertainty

uncertaintyOne of the things that makes finance endlessly fascinating (to me!) is that perfectly sound logic for one situation turns out to be perfect madness in another situation.

In my best moments I appreciate the ironies and contradictions. In my worst moments I despair for people whipsawed by the seeming complexities of financial choices.

Most middle-class folks grapple with one of these important choices – a home mortgage – at least once in their life. I’m a big fan of the choice to buy a home with a mortgage but even there, a controversial battle rages.

Anti-debt

dave_ramsey
Dave Ramsey

On one side of the ring stand the anti-debt gurus like Dave Ramsey. While Ramsey really wants his followers to pay cash for their homes (which is fairly absurd), he has strong rules about what to do if you decide to borrow. For example, Ramsey says

  1. Always make at least a 20% down payment, to avoid high interest charges and expensive private mortgage insurance.
  2. Always get a 15-year mortgage rather than a 30-year mortgage because you will pay it off sooner, typically enjoy a lower interest rate, and you’ll pay significantly less interest over the life of the loan.
  3. Never take on mortgage debt with a monthly payment that will command more than 25% of your take-home pay.
  4. Always avoid adjustable rate mortgages which shift the risk of higher interest rates from the lender to you.
  5. Never borrow additional home equity in the form of a home equity loan or line of credit.1

Ramsey – who built a real estate fortune and then went bankrupt by the age of 30 – preaches a low-debt or (preferably) no-debt financial lifestyle as a curative for people with past debt problems. He knows of what he speaks, and he has a certain strong logic for his points.

On the other hand, personally, I’ve broken each and every one of his rules. So I can’t actually advocate following his advice.

Pro-debt

On the opposite side of the ring, another financial guru Ric Edelman advocates the opposite approach.

ric_edelman
Ric Edelman

Since Edelman’s contrarian position flies in the face of conventional wisdom, I enjoy presenting his points even more.

  1. Only make the bare minimum down payment on your house – thereby freeing up your remaining capital for investing in the market, where you can earn an annual return higher than what you pay on your mortgage debt.
  2. Always get a 30-year mortgage rather than a 15-year mortgage, to take advantage of the tax deduction on mortgage interest.
  3. Never pay off your mortgage early or at all, because mortgages are the best way to borrow extremely cheaply. Again, use the borrowed money to invest profitably in the market.
  4. If the value of your house rises, consider freeing up the equity to invest, through a home equity loan or line, rather then let your net worth stay locked up and unused in the form of your house. That way, Edelman says, if the value of your house drops you’ll at least have withdrawn the money and have use of it for emergencies.
  5. Quickly paying down and eliminating your monthly mortgage payment is not an important goal because, as a homeowner, you’ll always have to pay insurance and real estate taxes anyway. Since you can’t eliminate those obligations, why bother trying to eliminate your mortgage payment?

You get the idea. When Ramsey says “Zig” Edelman says “Zag.”

Edelman presents some compelling math for his arguments. If you accept his assumptions then you could end up wealthier in the long run.

However, Edelman does not account for the psychological difficulty of saving money. Specifically, many of us benefit from the ‘forced savings’ of paying a mortgage, and few will have the discipline to take the extra monthly cash flow as a result of a 30 year mortgage and invest it for the long run, rather than squander it on iced latte frappuccinos.

As a result, I’m pretty sure some portion of people who take Edelman’s advice to heart will end up like the proverbial broke guy having to wear a barrel for pants. It kind of all depends on your specific situation.

My choices

In my own life I’ve had both adjustable rate mortgages and fixed rate mortgages. I’ve borrowed more than the conventional 80% limit. I’ve had 15-year and 30-year loans. I’ve paid extra principal on a biweekly basis, and I’ve also borrowed heavily against my home equity line of credit. I’d like to think I had compelling logic for each decision, or at least a sober mind for understanding what I was doing.

How to decide

I think my point is that the more wholly convinced a guru is, the less certain you should be. The stronger they lean in, the less likely they are to be correct in all circumstances, for all people. Ramsey’s got a great plan, for example, for people who’ve been bankrupt in the past or who have a history of debt problems. Edelman’s approach is closer to my own experience because he’s linking some risk-taking to long-term wealth creation, which I tend to do in my own life. But where you fall on the risk spectrum is a key determinant of their relevancy to your own situation.

Big Ideas vs Little Ideas

Nate Silver’s 2012 book The Signal And The Noise presents the dichotomy of a guru or pundit’s ‘big idea’ vs. ‘small ideas.’ While punditry rewards people who have ‘big ideas’ and ‘hot takes’ on topics, the reality is that certainty and big ideas come at a cost. Predicting the future – one of Nate Silver’s specialties – is a difficult business for people with big ideas. They rarely get it right. Instead, Silver advocates adopting a nimbler approach to observing the world.
When I read gurus like Ramsey and Edelman, I remind myself that their certainty is a sign of the ‘big idea’ thinking that Silver warns against, when we might be served better by smaller ideas, more responsive to changing conditions.

The more certain I am, the less likely I am to be wholly right.

 

A version of this post ran in the San Antonio Express News.

Please see related posts:

Book Review: The Signal And The Noise by Nate Silver

My 15-year mortgage – I am a Golden God

Rent vs. Buy a house

Home Equity Lines of Credit are awesome

The Latte Effect in my own life

 

 

 

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  1. I have strong pro-HELOC views, as I’ve written about in the past.

Lord Of The Rates Part III – Mortgage and Real Estate Market

Rivendell_mortgage_bankers

A version of this post ran in the San Antonio Express News.

Please see related posts: LOTR Part I – One Rate To Rule Them All,

and LOTR Part II – How Money Is Born

and LOTR Part IV – Consumer rates

Three rates for mortgage brokers under the sky…
One for the Yellen on her dark throne
In the land of FOMC where the money’s born

The mortgage bond market sets the major interest rates we experience as real estate purchasers and mortgage borrowers. Because these rates are market-driven, they change from one day to the next, even from one moment to the next.

In my Lord of The Rates narrative from an earlier post the High Elves of the Mortgage Market own the 3 Mortgage Rates of Power, setting 30yr, 15yr, and short-term adjustable-rate mortgage (ARM) rates.

In an Earlier Age, I worked with those High Elves on the Goldman mortgage bond sales desk.

“Bid $1 Billion Fannie Mae 30year 5% in June”
“100-23+”
“Done.”
“Done.”

As fast as it took to read that, a mortgage-originating bank like Wells Fargo or Bank of America would promise to deliver a billion dollars worth of a diversified bundle of 30-year home mortgages, all with the same interest rate, two months from now, to Goldman’s mortgage bond structuring department. And the buyer responded with how much over face value they’d pay

The price Goldman paid for that bundle depended on an expectation of what price end-user bond buyers would pay for mortgage bonds, two months ahead.

Using Elven magic – known as securitization – our team at Rivendell would weave the dross of three thousand or so home mortgages into shimmering golden threads of valuable bonds, desired by investors all throughout Middle Earth.

That price paid – which again, fluctuated from moment to moment with the interest rate markets – ultimately drove the rate a home-buyer could lock in today.

The Fed funds rate – The One Rate To Rule Them All – anchors the interest rates that mortgage bond investors are willing to accept. And that One Rate To Rule Them All is about to go up.

Higher Rates Coming

When the Fed dropped the Fed funds rate in surprise moves in 2001, and again in 2008, mortgage bond investors accepted lower interest rates on their mortgage bonds. That lower rate allowed mortgage borrowers to save money, either by locking in new, cheaper, mortgage loans or through refinancing their existing mortgages.

rivendellUnfortunately, for home owners and buyers, we’re going the other way now.

When the Fed resets to a higher Fed funds rate – which it will do in either June or September this year – the bond investors of Middle Earth react by demanding higher returns on their bonds.

That demand for a higher return by bond buyers means mortgage originators will require future homebuyers to lock in higher rates on their mortgages. In addition, fewer borrowers will want to refinance, since they can’t save money that way.

Of course, I’m simplifying the timing. All interest rate markets are forward-looking, meaning that the probability of higher interest rates in the near term gets ‘priced in’ to interest rates throughout the mortgage system.

What I mean is this: The High Elves of Rivendell concern themselves with the future, even before it comes to pass. Professional mortgage bond investors already know rates will go up soon, so they’ve already begun to demand higher mortgage rates ahead of the FOMC’s move.

Still, higher rates will certainly affect real estate prices in the future.

Rates effect RE prices
At the risk of stating the obvious, higher mortgage rates tend to dampen the price of real estate.

Bag End for sale

With higher mortgage borrowing costs, home-buyers (as well as commercial real-estate buyers) typically can afford to buy less real estate for their money. So prices go down, or stay down, to match the newly-limited demand.

To give a quick example: A hobbit of Bag End with a $200,000 mortgage at 4% for 30 years on his burrow could expect to pay $956 per month.

That same hobbit, asked to lock in a 5% mortgage six months later – following an interest rate hike – would need to pay $1,075 per month. The $120 extra per month might be the difference between being able to afford the monthly cost of a new burrow – or not.

Since the real estate market – residential, commercial, and raw land alike – depends on borrowed money, the demand for real estate is very sensitive to interest rate changes like this.

Of course this was a huge reason why policy-makers desperately sought to keep rates low following the 2008 Credit debacle. Low interest rates provide a huge boost to real estate demand and therefore prices.

Bag End ComparablesThis in turn allowed the Sackville-Bagginses, in danger of foreclosure, the chance to work out their problems, sell at less of a loss, or deleverage their burrows less desperately.

Hopefully the Sackville-Bagginses have already locked in a low mortgage rate on their burrow, because it gets harder to afford real ownership once rates go up.

When the One Rate To Rule Them All jumps this year, the mortgage and real estate markets will be among the first to feel it.

 

Please see related posts:

The LOTR – The One Rate To Rule Them All

The LOTR – How Money Is Born

And The LOTR – Fed Funds effect on Consumer Rates

 

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Judgment vs Objectivity – My Recent HELOC Renewal

A version of this post ran recently in the San Antonio Express News.

My wife and I recently renewed our home equity line of credit 1  with our bank.

nutella_is_the_best
HELOCs are as good as Nutella

When the notary at my bank had us in the room for 30 minutes busily initialing and signing many dozens of pages per a minute – pausing approximately 0.7 seconds per page – my mind began to explore the absurdity of it all.

Am I supposed to have read each page? Does this signature here actually compel my compliance with everything on the page? Really?

Hidden in the fine print of these documents, the bank probably slipped “And, henceforth I, Michael Taylor, by my signature below, do solemnly agree to wear a rubber ducky costume to work every day. Also I agree that my banker is the super-duper coolest person ever” and there’s no way I would have caught that in the fine print.

And yet, I signed. My cursive name must mean I agreed to it all. Yes, I agreed to whatever they wrote down there!

I’ve worked on many sides of the mortgage business for many years now, so I understand the point of this paperwork. To wit, the papers have zero to do with serving borrowers and 100 percent to do with creating a CYA paper trail – a paper trail that serves the lender, not me, if things go badly.

I get that.

I wish I didn’t have to participate in this charade of me ‘agreeing’ to something which I am unwilling to read thoroughly, that the bank knows I am not reading, and yet the bank also knows they can take me to court and win by arguing successfully that I agreed to all their terms, if I fail to comply with said terms.

We’ve all had that experience of mindlessly signing and initialing page after page of unread documents.

What do all those initials and signatures, the unreadable documentation, plus all of the regulatory morass that underpins it all, stand in the place of? Human judgment.

nail that sticks outWritten rules substitute for our ability, or the bank’s ability, to make individual decisions specific to a situation.

But here’s the weird thing that I returned to in the midst of signing my name dozens of times in front of my notary: this dehumanization of the decision process is a good thing. This automated decision-making process works to our advantage.

We think we want our bankers to be able to use their judgment. But we really don’t.

We think we would all be better off if we had a banker, like George Bailey from It’s a Wonderful Life, who could look us in the eye and say: “Here’s a loan, Taylors, I trust you. Don’t worry about all that boring paperwork, your handshake is enough.”

We’d skip out of the bank buoyed by Banker Bailey’s great judgment and trust in our solid character.

To the extent that George Bailey’s world ever existed (it may have, or it may not have) I don’t think that was a better world for borrowers for at least for one important reason: Borrowing costs.

All the impersonal unreadable language assists in making mortgage loans like my HELOC (Home Equity Line of Credit, but you know that) one of the cheapest ways to borrow on this planet.

Banks do not really underwrite mortgage loans anymore. Instead, they originate mortgages for a fee, and then feed the mortgage bond investor system with similarly situated mortgage loans. To feed that system, every single mortgage or HELOC must conform precisely to the standards of bond investors.

The mortgage bond market attracts a billion of dollars of investment capital on a daily basis 2 to fund home ownership. That money invested in mortgages gets offered at rock bottom interest rates precisely because of the uniformity enforced inside a mortgage bond.

Any non-conformity in the mortgage underwriting process makes the loan ineligible for inclusion in a mortgage bond structure. “The nail that sticks out must be hammered down,” as the Japanese cliche goes.

With a signature missing here or an initial missing there, the bond structuring companies would kick our loan out, and the bank would get stuck with an inefficient product on their books, which is the last thing they want.

I’ve never worked in the Wal-Mart supply chain, but I’ve read about the incredibly strict standards by which suppliers must meet packaging specifications to get their stuff into Wal-Mart stores. Those inflexible standards help produce the rock-bottom Wal-Mart prices. Human judgment or flexibility with the rules would raise prices in Wal-Mart, just as it would for my HELOC.

walmart_mortgages
All things must be automated

When my wife and I signed our HELOC recently, we were the product being packaged for sale into the mortgage bond market. We got a great interest rate, and it only required an assembly-line approach to signing everything.

 

Please see related posts

Ask an Ex-banker – Home Equity Lines of Credit

Why You Hate Your Bank – Lack of Judgment

 

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  1. By the way, home equity lines of credit are the bomb. Tangential to the following discussion, I believe home equity lines of credit – despite causing widespread financial destruction in 2008 – are the best invention since Nutella on toast. But that’s a discussion for another time and place.
  2.  How do I get that number, you ask? Great question. The US mortgage bond market added up to $8.7 Trillion in mortgage bonds at the end of 2014. At a weighted average coupon of 4.5% (I made that up but it feels average-y at this point) that would generate about a billion dollars in interest per day. Factoring in principal repayments the US mortgage bond market has to attract more than a billion dollars every day just to stay the same size.

The New Yorker on Housing and Mortgage Subsidies

James_Surowiecki
James Surowiecki, The New Yorker

I can’t say there’s anything particularly new in James Surowieki’s New Yorker article on the various ways we subsidize home ownership vs. renting, but taken as a whole he provides a great starting primer and review of the arguments.

I mean, don’t get me wrong, home ownership is awesome for someeven for many – but I don’t think we talk enough about whether it’s such an unimpeachable good thing that it deserves quite so many subsidies.

We traditionally have subsidized home ownership in myriad ways.

  • A quasi-government guaranty (followed by a $800 Billion assumption of liabilities in 2008) of mortgage guarantors Fannie Mae and Freddie Mac.
  • Federal FHA/VA loan programs for first-time home buyers and veterans to encourage home-purchasing with as little as a 3% down payment.
  • Mortgage-interest tax deduction ($200 Billion in foregone tax revenue).

And yet, the benefits and effects of such subsidies are questionable

housing_as_investment

  • We do not have an appreciably higher percentage of home-owners in the US vs. other countries that lack such subsidies
  • 3% to 10% down-payment mortgages default more frequently (50% more frequently) than 20% down-payment mortgages, serving both home-buyer and bank poorly.
  • Americans tend to react to the mortgage interest subsidy by buying bigger homes, rather than saving the money.
  • The mortgage interest tax deduction is regressive, in the sense that it primarily benefits folks with incomes higher than $100,000, and a household with a larger home and mortgage benefits more than a household with a more modest home and mortgage.
  • Houses, which often constitute a high portion of household net worth, are a very illiquid investment.
  • Housing, as a sector, tends to add volatility to the economic cycle – making booms more manic and busts more depressive.

Surowiecki summarizes nicely: Given the extraordinary subsidies aimed at the sector – compared to other worthy areas of subsidy – is it all worth it?

 

Please see related posts:

What we do when we invest in a house

Housing – The Opportunities

Housing – The Risks

The New HUD Secretary encouraging home ownership, and me cringing

Book Review: Edward Conard’s Unintended Consequences

 

 

 

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Mortgage Lending Made Easy Makes Me Uneasy

home_mortgagesYesterday was a pretty big day in the slow unwinding of post-crisis mortgage-lending policy making, according to the Wall Street Journal.

I’m not going to jump up and down and declare that this latest negotiated relaxation of federal mortgage standards means we’re back to the pre-Crisis madness.

On the other hand, it appears that all the tough policy talk – about shoring up lending standards, winding down Fannie and Freddie, requiring strict 20% down payments for new mortgages, and requiring mortgage securitization banks to retain at least 5% of the bonds they make to have ‘skin in the game’ – just went flying out the window yesterday.

As I mentioned recently, HUD is very focused on increasing lending, even if it means pushing banks back into the subprime space. One problem that HUD and the Federal Housing Finance Agency face is that mortgage standards appear high and tight for anyone with less than perfect credit or the traditional hefty 20% down payments.

In addition, mortgage originator and aggregator banks are scared to death of any misstep in the underwriting process, because that allows Fannie and Freddie to kick the mortgage back onto the mortgage bank’s balance sheet. Mis-steps, even tiny ones, also expose banks to the kinds of government lawsuits for which they’ve paid many billions of dollars in recent years, in what I basically believe to be “settle and quickly move on” situations for banks, rather than outright winnable cases for the government (but that’s another long story.)

Yesterday, Mel Watts of the Federal Housing Finance Agency announced in a speech to the Mortgage Lender’s Association:

1. A relaxation of the 20% down payment requirement for conforming loans, to as low as 3% down for certain qualifying buyers. Details to follow in coming weeks.

2. A new set of easier requirements that make it less likely Fannie or Freddie will kick back non-underwriting compliant loans to underwriting banks.

Separately, the FHFA indicated that banks will not have to carry 5% of the risk of mortgage bonds, if borrowers did not provide a 20% down payments. Banks hated that rule, and they got their wish.

These steps will clearly please both mortgage banks and borrowers in the short run.

In the medium to long run, we’ve definitely taken a giant leap toward riskier mortgage lending.

John Carney at the WSJ says

The rule [regarding banks holding 5% of mortgage securities themselves] isn’t just a small step back for mortgages, it is a giant leap backward for the entire financial system.

Those are fightin’ words.

 

Please see related posts:

New HUD Secretary seems to advocate for increased subprime lending

HUD disagrees that they advocate subprime lending, so let’s go to the transcript

Mortgages Part VIII – The Cause of the 2008 Crisis

Mortgages Part V – I Want A New Drug

On Housing Part III – 7 Big Opportunities

 

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