Lee’s Notes: as most of you know, I am pretty hard and heavy with investing in indianapolis real estate.. I found the following article very interesting. It speaks mainly towards investor loans, and I’ll carry it out over 2-3 days. It was written by Vena Jones-Cox(The real estate goddess).
The Past, Present, and Future of Institutional Loans
It’s not necessary to use banks to buy real estate…but it sure helps to have them as a resource, ESPECIALLY in a market where the 1-2 year terms that most private lenders want might balloon before the resale market bounces back.
We’re in a very odd market right now where on the one hand, banks are desperate to sell their portfolios of REO properties, but on the other hand don’t want to loan investors money to buy or fix them. Interest rates are low and attractive, but loan programs are extremely limited. Few qualified homeowners are in the market to buy, and a lot of effort is being put into making money available to them. Lots of qualified investors would like to buy, but there are almost no programs available to help them do so.
In almost any other industry, demand drives a business’s product mix. In real estate, for instance, there is much less demand for “retail” houses, so investor are busily supplying the demand that’s replaced it: lease/options and rentals. Unless we’re insane, we’re not sitting on properties month after month after month, stubbornly insisting that someone “should” buy our house—we’re filling the actual desires of the market, which is to rent now, buy later. So why are banks sitting on a gazillion dollars worth of cash, insisting on waiting around for the next homebuyer to walk through the door, when there are tens of thousands of investors clamoring to borrow the money, but shut out by the lender’s policies?
A Brief History of Mortgage Lending
In order to understand why there’s a severe shortage of money in the market today, it helps to understand how the mortgage lending industry has changed in the past 80 years or so.
It used to be that all banks made money the same way: by taking in depositor funds and loaning out those funds at a higher rate of interest, largely secured by real estate. You’d put your money in a savings account and get 2% interest; the bank would then take your money (and that of a bunch of your neighbors) and loan it to Harry Homebuyer at 7% interest. The 5% override (along with the upfront loan costs) was how banks made a profit for years and year.
This system makes a lot of sense on the face of it; however, the practical result of it was that mortgages were LESS obtainable under it than they are today. The banks making these loans faced 2 natural limitations: the amount of money they had available to lend and the amount of risk they were willing to take on a particular borrower or property, as well as overall.
In fact, as late as the 1930s, it was common for the local bank to offer mortgages only if the borrower could put 50% down on the property, and only with 5-10 year balloons (which is where the common plot device of the evil, mustachioed character ready to take the old homestead came from…since most mortgages ballooned, many owners lost their properties not from inability to make the payments, but from inability to make the BALLOON payment).
Banks at the time took an obvious risk in loaning out depositor money (remember Jimmy Stewart explaining, “Your money is in Frank’s house, and yours is in the Smith place…” during the run on the Bailey Savings and Loan?). But there were other risks as well—any losses had to be made up from profits (remember, we’re talking about the days before “mortgage insurance”, and if interest rates on DEPOSITS rose, all existing mortgages became less profitable (or, if the deposit rates climbed too much, could actually begin to lose money). Given that all the risk inherent in making mortgage loans stayed with the bank who made them, it’s not difficult to understand why the terms were so harsh (at least compared to what we’re used to), and why home ownership remained a “dream” to most American families until after World War II.
Needless to say, the Great Depression made things even worse—the real estate market crashed along with the stock market, and between the extreme poverty of most Americans and the deep distrust of banks, little money was available for loans in any case. In order to stimulate the real estate market and take some of the lending risk off the backs of local banks, the Federal National Mortgage Association was created in 1938.
Originally a government program, FNMA borrowed money at low rates overseas and used it to buy mortgages from the original lenders. This allowed your friendly neighborhood bank an almost inexhaustible supply of money to loan, and a new way to profit from mortgages with almost no risk. Instead of worrying that rates on depositor money might exceed mortgage rates over the long term, banks could now move the long-term risk to FNMA simply by selling the mortgages almost immediately—and could make their profits by charging fees for the origination of the loan. So now, $100,000 in deposits could generate $1,000 fees over, and over, and over in a single year as the deposits were replenished by the purchase of the mortgage by FNMA.
The creation of FNMA (and of FHA and VA insured loans, also during the 30s) caused a sea change in the mortgage industry. Balloons in residential owner-occupied mortgages disappeared practically overnight. 30 year terms with 20% down, as opposed to 50%, became the norm. All the risk associated with longer terms and lower down payments was taken away from banks and put in the hands of the taxpayer, and suddenly home ownership was an option for many more Americans.
The secondary banking system created by FNMA set the stage for the massive changes in the mortgage industry in the late 60s and early 70s. With much of the profit from “conforming loans” (i.e. those that qualified for purchase by FNMA and its much younger cousins GNMA and FHLMC) coming from up front fees and servicing fees rather than yield spread, it only made sense that mortgage lending would become a business in itself, separate from taking deposits. With Countrywide leading the way, mortgage lending became a national, rather than local, business.
Meanwhile, back in the world of real estate investing, the rise of the conventional loan market created an interesting problem. Many banks stopped making any loan that couldn’t be sold on the secondary market—and that included loans to entities, loans for renovation, and, on and off, loans of more than 80% of the purchase price of properties. For the kinds of deals we buy (some of which cost more to FIX than they do to PURCHASE), conventional financing has always been a reasonable option for Refinancing, but not so much for buying properties in the first place.
So, even as the rest of the banking world moved on to making primarily “conforming” loans, some smaller lenders realized that there was a profitable niche to be filled serving the needs of real estate investors. Yes, it was a higher-risk way to make money, primarily because a mortgage made on a junker-type investment property had to be “portfolioed” (kept by the bank rather than sold on the secondary market), but given that the borrowers were willing to pay higher fees and interest rates, lots of smaller banks were ready, willing, and able to fill the need.
That is, until the real estate market crashed in 2005. Suddenly, the little banks around the country that had been the only haven for investors looking for institutional money began pulling programs off the table right and left. By early 2007, only a small fraction of the “portfolio” lenders in the country were still making money available to buy and rehab properties, and those that were had restricted the programs to such an extent that the terms were impossible for many investors to meet.
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