Real estate investors get paid more for what we know than for what we do. That’s why I write this blog. Intellectual capital is the renewable resource that will get you through these frenetic economic times. Banks are nowhere to be found and the Federal Government is trying to fix years of neglect in a weekend. While I agree that owning a home is part of the American dream, the reality is that you are welcome to dream but when you prove that you have the income and the discipline to pay your bills, then you may qualify for financing. When the government says to the banks, via the Community Reinvestment Act, that they MUST loan money to people who probably won’t pay it back…something is terribly wrong. In spite of noble intentions, our lawmakers frequently mire us in the Law of Unintended Consequences.
“A people that values privileges above principles soon loses both.” -Dwight D. Eisenhower
So now the banks got sloppy and made loans to anyone and everyone. There are points and fees and lots of places in the lending process for many folks to take a piece of the action; originators, brokers, accumulators who package and sell mortgage-backed securities, and finally Wall Street – who buys this package of obligations representing income streams secured by notes nobody can seem to find. There are ample opportunities for unscrupulous lenders, broker, and buyers to collude and defraud the system to feed their greed.
A contractor friend of mine borrowed $200,000 a couple of years ago to purchase a home for his family; his borrowing costs were over $13,000. That’s right, effectively 6.5% of the mortgage amount in fees to get an Adjustable Rate Mortgage. Since real estate prices were rising, the lenders were happy to roll the loan costs into the mortgage. My friend was one of millions, and now he, like millions of others, is in default. No one was minding the store and now the government wants to step into the free enterprise system. Personally I don’t like it! But beyond my personal bias, it is probably a necessity because most people don’t understand the workings of money as we do.
What concerns me most is that there has been no expert testimony or input provided after the first bailout bill failed. The government has an opportunity to do something good which could actually protect Main Street while helping Wall Street without rewarding those who did wrong. Granted someone will get the short end of this deal but maybe they will be more enlightened next time. History virtually guarantees a next time!
To me this is a simple investor problem and an excellent opportunity for us to learn. You have hard assets in the form of real estate; you have non-performing assets in the form of notes secured by mortgages on the real estate, and you have a lack of liquidity because lenders have to put up reserves against defaulted loans (loan loss reserves). These reserves cannot serve as capital for new loans which would generate interest income, so the credit markets are drying up due to insufficient capital. So what’s the solution?
The government could replace 50% of the market liquidity by paying fifty cents on the dollar for the defaulted notes (yes, they can buy defaulted paper just like you and me). At a 50% discount, they should have enough spread to modify the terms of the mortgages, season them for 6 months and then sell the assets at 80 to 85% of face value. The lenders and their share holders will take a loss but then they were the ones who made the ill advised loans. They will recover over time. Additionally, there will be no free lunch to those who borrowed unwisely. They will still have to repay their obligations only on more favorable terms. Excess housing inventory will be absorbed and the cycle of “business as usual” will return. This will take some years but it will get the system moving again.
The Resolution Trust Corporation of the 1980s took about six years to liquidate the assets of the defunct Savings and Loan industry and just look at the boom times that followed. Unrestrained greed coupled with bad legislation will always drive our economy in directions that cause financial pain. Even so, the free enterprise system has proven time and time again that when the markets speak they can police themselves. The lack of discipline and diligence is what caused buyers to buy more house than they needed and the lack of discipline and diligence allowed lenders to throw depositor’s cash around like drunken sailors. This same lack of discipline and diligence by Wall Street bought highly leveraged portfolios without having a clue as to the quality of the underlying assets.
It’s time for the biggest short sale in history. The U.S. government is the only buyer I know who could eat this elephant in a hurry and take the time to digest it. Instead of $700,000,000 they could probably do it for $350,000,000 and then quick sale some of the assets right off the bat for a 5% to 10% spread (yes, that’s wholesaling). Then they could begin the process of re-pricing and repackaging these loans and selling a decent product back to Wall Street to resell to our foreign friends who are also getting hammered by current events. The beauty is that the U.S. government could actually make a profit on this deal and buy down a piece of our national debt with the proceeds. It would be similar to when I encourage my coaching clients to use income to pay off their revolving debt and then invest in good growth building debt. Maybe our Congress and Senate should attend a few real estate seminars!
So what do we do now?
Check out my next post which is the first in a two part series about managing in this market.