MONDAY: MAIN QUESTION OF THE DAY

How the United States Housing Market Failed! The Subprime Loan...Education 101

The so-called day after "hangover" from the fast and loose lending spree that helped fuel the real estate boom during the first half of this decade keeps getting worse, with a continued fall out among lenders who catered to high-risk (or "subprime") borrowers. Several dozen lenders have closed their doors because the Wall Street firms who have provided their funding will no longer do so. 

SO THE MAIN QUESTION IS

What is a subprime mortgage?

 Generally speaking, it’s a home loan made to borrowers have low or no down payments and/or poor credit ratings. Although most home loans do not fall into this category, subprime mortgage programs have proliferated in recent times as the "rising tide that lifts all boats" propped up home values across the country and emboldened lenders to take on more risk. 

As real estate values moved higher after 2000, lenders expanded the use of subprime loans, adding enticing features that made home ownership possible for people who could not qualify for traditional mortgage loans. 

What went wrong? 

Increasingly, lenders approved subprime loans to shaky credit borrowers with little or no proof of income, little or no down payment funds, and with low "teaser" starting interest rates and payments. Some of these "stated-income" loans became referred to as "liar loans." 

Wall Street encouraged this behavior by bundling the loans into securities that were sold to pension funds and other institutional investors who were seeking higher rates of return. 

Seasoned real estate industry professionals watched the trend toward "easy money" loans with concern. As risky home loans soared in popularity, federal banking regulators were repeatedly warned that more borrowers were getting trapped in mortgages they simply could not afford. 

As long as home values rose, borrowers gained equity and could continue to refinance. However as interest rates rose and home values declined or flattened many borrowers could no longer get new loans and could no longer make their payments when their initial teaser rates expired. 

Rising defaults and delinquencies have caused more stringent underwriting standards and in some cases the outright elimination of certain loan programs. 

The "Piggyback 2nd Lien" Here is an example: 

Property Sales Price: $300,000

Buyer's Down Payment: $15,000

Balance Due: $285,000

1st Lien Loan 80% LTV: $240,000

2nd Lien Loan: $45,000 

A prospective buyer with shaky credit purchases a home for $300,000 and can put down 5% of the purchase price or $15,000. The lender agrees to lend the buyer/borrower a 1st mortgage loan for 80% of the sales price or $240,000. 

In addition to that mortgage, the lender also agrees to lend the remaining $45,000 to the buyer by allowing for a 2nd lien mortgage to be placed against the property, often known as a "piggyback" 2nd lien mortgage. 

So the buyer borrows a combined total of $285,000, and along with the $15,000 down payment is able to cash out the seller completely for the $300,000 purchase price. 

Typically the interest rates on the 1st lien mortgage are lower than that of the piggyback 2nd lien mortgage, which in some cases is called a Home Equity Line of Credit (HELOC) loan that is then drawn on. 

As long as the lenders were able to continue to originate these piggyback 2nd lien mortgages and Wall Street continued to have an appetite for them, this was wonderful for the sellers because they were getting ALL CASH for the sale of their property. 

Prudent lending or not? 

Let's take a look at that very tenuous $45,000 piggyback 2nd lien and see how unsafe it really can be. With a buyer/borrower who has little or no money of their own into a property, there is little or no true equity. If times get tough for such a borrower, the incentive to work things out becomes precarious. 

Add to this the sloppy credit history of the borrower, and that 2nd lien mortgage carries with it a tremendous amount of risk because it sits behind or "junior" to a much larger (and superior) $240,000 underlying 1st mortgage lien. Its no wonder Wall Street will no longer purchase such high risk "throw away" 2nd lien mortgages. 

Cause and effect 

Now buyers, their Realtors, and the buyers' mortgage brokers are trying to convince sellers to carry back the $45,000 piggyback 2nd lien mortgage. Yet most sellers can clearly see how uncertain and perilous holding such a smaller 2nd lien mortgage can be to their financial well being and refuse to do so except under extreme circumstances

An alternative way using seller financing 

What if you could structure the sale of a property to a prospective subprime candidate and not have to take back any high risk dangerous piggyback 2nd lien mortgage while still achieving a respectable all-cash sum when your property sells? Might this make more sense to a property seller? 

Using some of the creative and alternative methods involving the seller providing the financing (owner financing), this is very achievable. Let's take a look how: 

Property Sales Price: $300,000
Buyers Down Payment: $15,000
Balance Due: $285,000
1st lien Loan 95% LTV: $285,000 (seller financed) 

Step one: 

Let's the same $300,000 sales price and same $15,000 cash down payment from the buyer. However . . . 

Instead of the buyer being limited to only 80% loan to value (or $240,000 loan from a lender), the seller agrees to finance the buyer under the terms of the sale and agrees to take back a purchase money mortgage in the amount of $285,000 (the $300,000 sales price minus the $15,000 cash down payment). 

Step two: 

Now I know what a lot of you are saying: "If I provide seller financing to the buyer, how does that equal me getting cash?" The second step is the answer, and it involves the pre-sale or conversion of this $285,000 seller financed mortgage into a cash lump sum. 

Assuming that 

Some time was spent checking out the prospective borrower's employment, stability, overall credit profile, and credit scores, and the negotiated repayment terms of the seller financed instrument were commensurate with how strong (or not) these borrowers stacked up. . . then (using the services of a cash flow professional), the $285,000 seller-financed mortgage can typically be sold immediately to generate somewhere between $256,000 to $262,000 or more as a lump cash sum.

The seller receives the $262,000 cash sum from the sale of their seller-financed mortgage plus the $15,000 down payment--or a total of $277,000 in cash proceeds and it negates their having to hold a very, high-risk $45,000 piggyback 2nd lien mortgage as in the example above. 
Many sellers--especially investors, holding unsold homes in "inventory" will agree that $277,000 cash in hand today is far better than $255,000 cash (the $240,000 1st lien mortgage proceeds plus the $15,000 down payment) and a high-risk $45,000 piggyback 2nd lien mortgage they may have trouble later collecting on in the future.

For any questions, please comment below. For investment services, leave a message at 314-246-9484 ror you can email at dhibb99@gmail.com