DISQUS

Thanks very much.

I hope someone out there has their emails.

Krassen.....My example may have seemed extreme to you, but it happened. To a friend of mine. "Value" is always a subjective amount, and this shows you what can happen when value is suddenly radically altered by often arbitrary outside forces.

The bottom line of any lending decision should be "Can the borrower make the payments outlined in the loan docs?" In an investment property you look at the operating income. In a person's home, you look at that person's job income. Beyond that, how much real money (cash or equivalents) do they have in reserve, in case they lose a big tenant or lose their job. Pretty simple, really.

The lenders got way too fancy (greedy) for their own good, and started creating products that jacked up their returns, but introduced an element of danger into the situation. Due in 5, 7 or 10 years? ("Bullet" loans, as they were called, 'cuz if you couldn't refi them when they came due you might as well put a bullet in your head). Hybrids, where the rate was only fixed for a few years, then started to ratchet up. Liar loans, where you could tell the bank you made $150,000 a year, when you really made $45,000. Just lots of bad lending. Result? What we really have in this country is a reset problem, more than a value problem.

And all these percentages people are tossing around? They really don't matter. It's all a paper loss until someone forces you to take a real loss. If the folks in Washington can figure out how to slow down, take a deep breath, and stop kicking over the first domino, we could get out of this mess with far less pain than we've seen so far, and I fear is coming.

One way to do it would be for this new Super FHA to say to a home borrower in trouble, "Show us your tax return. Tell us what you really make. We'll then tell you how much you should be spending on your mortgage payment. And just like the IRS, we're going to make it easy on you to make that payment. We're going to take it right out of your paycheck. Your employer can send it straight to us. Then we'll apply it on an interest only basis to your outstanding balance at the base, true interest rate on your loan (not some teaser rate), before any resets started to kick in. At that interest rate, we'll figure out what your max loan amount should have been. If you owe more than that amount, then the differential gets paid back down the road when you sell, to whatever extent possible. Kind of an "equity sharing" arrangement.

The lending bank has to take a haircut on its return. The Wall Street house that packaged the loan for resale has to take a trim too. And the investment fund that bought the deal has to take less also. Tranches be damned. Everybody got caught with their hand in the cookie jar and chocolate all over their mouth, so everybody goes to their room for a while. Theoretically the smartest guys on the planet - Ivy League MBAs and quants working 20 hours a day for the big names on the Street - can't seem to figure out how to value these pools to date, so why try? You win some, you lose some. At least you won't lose it all if the right people can think this through..

The guy in the house gets to stay there, and doesn't have to move out. He won't be making any profit on the deal for a long, long time, but at least he's not in the street telling his kids he's sorry. The banks don't have to screw around with foreclosing on thousands of houses and getting 30-40 cents on their loan dollar at some auction at a Holiday Inn. Everybody loses a little, but that means everybody also wins a little. No more Bear Stearns meltdowns. No more self-fulfilling death spirals into the ground. It's a big bump in the road, but we'll all get through this if we just keep our heads and apply some crisis management skills and ingenuity to this whole situation.

First thing I want to say is that you cannot rely on appraisers to set value. I was heavily involved in the real estate syndication business in the late 80s when it hit the fan in that sector. The mantra then from the appraisers was "You blamed me on the way up. You're not going to blame me on the way down." So they arbitrarily cut values by 20-30% when nothing had changed with the economics of the building. In no small way they created a self-fulfilling prophesy environment. Same thing will happen now if we allow them to set values, which obviously has a big impact on the amount of money one can borrow to finance a purchase.

Recently I originated commercial mortgages for one of the major banks that's been in the news due to their prominence in the home loan market, and regardless of how thorough and conservative we were in our preliminary underwriting, the bank would not commit to a proceeds amount until the appraisal came back a month later. It was as though the clouds parted, and holy tablets came down from on high with the magic numbers carved into them. Whatever the appraiser said was effectively cast in stone.

The most important metric to focus on is the ability of the building and/or borrower to pay the debt service. In the case of an investment property, that comes from the rents. In the case of a home, that comes from the borrowers income.

In the commercial real estate crunch of the early 90s, many loans had 7 or 10 year due dates, which the borrowers expected to be able to refinance when they came due. But many could not. Why? Not because the building wasn't generating enough NOI to cover the debt service, but because there was no money available. Period. Virtually all the commercial lenders were saying "We've been told we have to double our capital vis-a-vis our loan portfolio, and the easiest way to do that is to just not make any new loans until half our existing loans are paid off, which effectively accomplishes that." So they all sat on the sidelines.

In the meantime, those same lenders were expecting the loans they had outstanding to be paid off. But where would those borrowers get new money to do so? They couldn't. So even though the net income from the properties could easily cover the debt service, when the due dates rolled around and the loans were not paid off, those loans were technically "non-performing loans." Then the government regulators swooped in and made the banks start foreclosure proceedings. Which of course included performing the all-important appraisal. Suddenly that office building which had been purchased for $10M seven years ago, for $4M cash and a $6M loan, was now worth only $7M in the eyes of the appraisers. "Oh my," cried the government, "we can't have a $6M loan on a $7M building on the books of a bank!! That's a loan-to-value ratio of 86%!! What shall we do?" There was a lot of huffing and puffing from Washington, and finally they formed the RTC, which took the property from the bank, which had taken it from the borrower, and of course they had to conduct a fire sale to get rid of this horrible "non-performing " asset, so they sold it to Sam Zell for 40 cents on the dollar, or $2.8M. And they dusted off their hands and walked away feeling very proud that they had at least manged to salvage SOME value from this terrible debacle. Thank God guys like Sam were there to take these non-performing properties off their hands for them! And the good ole taxpayers picked up a chunk of the difference.

Mind you, that office building was throwing off $1,000,000 annually in NOI before the loan came due. The debt service on the loan was $600,000 annually. No problem making the loan payment every month. Nothing changed throughout this whole foreclosure and resale process. So Sam just swooped in and bought $1M of NOI for $2.8M, all cash. Not a bad cap rate, huh?

What should have happened was that the bank should have been allowed to ignore the contractual due date and continue to take debt service payments. The example property could easily generate enough to make the payment. The owners had $4M of their money in the deal. Given what happened, the owners lost their $4M of true equity, lost their credit rating, the taxpayers paid needlessly, some banks were needlessly pushed into failure, and the whole situation turned in to a big mess. Companies collapsed. People lost jobs. The economy suffered. Bad news all around for most of the players.....but not all of the players. Some rational thinking could have prevented much of that from happening.