Bad-credit loans, or hard-money lending, are returning as a way to finance residential real estate.
This is not the subprime fiasco. It will provide the liquidity the residential mortgage market has been lacking since those loans stopped in 2008.
There are no exchange-traded vehicles available for investing in this. But it will become a driver for the housing market very quickly, making mortgage financing available to borrowers who can't qualify under current secondary-market underwriting rules.
The new hard-money lenders are very similar to what was prevalent from the early 1980s to the late 1990s. In the early 80s, when residential mortgage brokerage was introduced, there were three primary routes a borrower could use. The secondary market consisted of all loan structures that would be packaged for inclusion in derivative securities, such as Fannie Mae, Freddie Mac, FHA, and VA. There were also direct lenders for borrowers with good credit and bad credit, both retaining and servicing the loans they made.
All loans are underwritten to the 3 Cs of credit: character, capacity, and collateral. Character is a measure of how credit has been managed historically, capacity is income and collateral is assets.
Traditional mortgage underwriting has objective guidelines and rules for all three areas. In general, the higher the quality of the loan, the lower the rate. And vice versa. If the loan quality was too low the borrower would not qualify for a traditional loan, but may for a hard-money loan.
The genesis of the subprime crisis was when Golden West Financial, through its operating subsidiary World Savings and Loan, began offering no-income-verification loans for self-employed borrowers.
They were underwriting mortgage loans based on character and collateral and did not require the proof of capacity. It was a radical concept, but logical at the time. Self-employed borrowers usually show little income on their tax returns.
In order to get a mortgage they had to provide their returns to the underwriters, who in turn had to analyze the tax returns to determine how much income was available for debt service. It was a hassle for the borrower and the lender.
World Savings developed their own systems to rely upon character and collateral and they did a fantastic job at it for many years.
As computer technology advanced, the ability to track and service loan portfolios increased and investment banks, principally Bear Stearns and Lehman Brothers, began to create objective subprime mortgage underwriting rules.
The problems began when they adapted the Word Savings model of no-income-verification loans to subprime loans. First, any two Cs were OK to get a loan. That turned into one C, then none. Those were called liar loans.
The new system for financing real estate will be bifurcated into lenders who make loans to be packaged for sale and lenders making loans for their own portfolio.
Banks, Real Estate Investment Trusts (REIT) and other registered financial companies subject to the Dodd-Frank Wall Street Reform and Consumer Protect Act are in the first group.
Lenders making loan for their own portfolio will be operated much the way they were back in the 1980s, with little regulatory oversight.
The SEC is considering not requiring REITs, hard-money lenders and other asset-backed issuers from having to register with the SEC.
This dismantling of the registration provisions that resulted from the growth of the subprime securities market is very positive for the housing industry. Investors and entrepreneurs will be able to supply capital to that market that they would not have otherwise.
Right now, the hard-money lenders are very active in California and are developing numerous kinds of loans that are not available through traditional lenders any longer. They are even recreating the old World Savings no-income-verification loan rules that worked so successfully.