The Mortgage Solution and the Refinance Trap: Why the Lender Always Wins with a Mortgage

Mortgage rates have been news for some time now. Coverage about mortgages has recently turned toward news of a potential rate decrease. This potential drop is such a relief to everyone in the real estate market that even President Joe Biden mentioned it in his most recent State of the Union address. Although the reference was a political move and this blog is not political, the President's attempts to use the activity in the real estate market to further his agenda is yet another reminder of the influence that mortgage rates hold on this country.

Homebuyer Programs to the Forefront

Wintertime is usually a slow time for the residential real estate market. Cold temperatures and budgets that are recuperating from the holidays make January and February low activity months. The weather in many areas also makes most construction activities a non-starter. During this time of year, seasoned real estate professionals get into prep mode, establishing or maintaining professional relationships, stepping-up marketing efforts and preparing properties for the Spring. Homebuyers can use this time to prepare as well, by getting their financing in order, paying off debts and seeking additional sources of funding. One source of funding that often is overlooked is homebuyer programs and downpayment assistance funds.

2023 Recap (No Clever Title This Time)

Yet another year has come and gone for TRET and it’s time for our annual wrap up. Let’s start with this blog. This year started for us with a focus on individual wealth generation through real estate. This noble goal dominated the blog for the first couple of months of the year and was continued in an expert fashion by this year’s guest writer—Sharon Wagner. All of our residential real estate articles have had a wealth generation theme and we will continue to honor this commitment to wealth generation going forward.

Strategic House Flipping as a Gateway to Adult Education Funding

By Sharon Wagner

Embarking on the path of higher education as an adult can be a financially daunting endeavor. In the quest to secure funding for this journey, the realm of house flipping presents an innovative and viable solution. This guide is designed to arm adult learners with strategic insights, seamlessly interweaving the art of real estate investment with the pursuit of academic goals, thereby transforming financial barriers into opportunities for growth and success.

Industrial Real Estate: A Normal Market for a Somewhat Normal Time

Recently coming off the effects of nearly two years of rising interest rates by the Federal Reserve, the real estate market has been in a state of constant change for the past 18 months. As this blog has extensively discussed, real estate is very dependent on interest rates, as they influence property loans, cap rates and ultimately, property prices. Despite the recent period of adjustment, the economy seem to show signs of normalization, with mortgage rates, consumer loan rates and even treasury rates settling at levels much higher than those of the previous two years. By all indicators, it seems like our economy and we seem headed for a soft landing. No market has internalized the current state of the economy more than the Industrial Real Estate market.

TRET the Podcast Episode 16: Interest Rates

Join TRET for it's 16th episode, as Stephon discusses the effects of current interest rate activity on the real estate market.

TRET Episode 16: Interest Rates

Stick With Properties—For Now

Stephon Martin

It is an interesting time in real estate—we stand on the precipice of the ending of a national foreclosure moratorium, interest rates are extremely low, the housing market is red-hot, and the commercial market is still unpredictable. What should a real estate investor do now? While there are a number of options that can lead to success, there is one caution—stay away from whole loans.

Cautioning against whole loans almost goes against the very nature of this blog, which promotes all profitable methods of real estate investment. Whole loan trading and valuation is the very reason why I started this blog and whole loan investing can be a great way to find hidden value real estate. That said, the following are various reasons why whole loan investment is not the best strategy in the current market:

12 Baffling Mortgage Acronyms Explained (UK)

Hello TRET Readers/Followers:

Please check out the Tembo article below regarding mortgage acronyms in the UK:

12 Baffling Mortgage Acronyms Explained

Foreclosures and the Moratorium

Stephon Martin

The Biden administration has extended the COVID-19 moratorium on foreclosures to July 31, 2021. Totally avoiding the policy and ideological discussions that could be had about such a decision, one thing is apparent—the additional month extension will increase the backlog of foreclosure and eviction cases that courts around the country will face once this moratorium has ended. Absent any legislative changes, the implementation of creative government programs mitigating distressed loans or both, foreclosure filings, executed foreclosure judgments and foreclosure-related evictions are all set to see an uptick over the next year.

An increase in residential foreclosures and evictions is certainly bad news for affected homeowners and tenants, who will have to find new living arrangements, undergo costly moves in short timeframes, uproot their lifestyles and, in some instances, face long term financial effects. Increasing foreclosures will also serve as a market correction in the real estate market, which is currently driven by inventory scarcity. Amidst the market change and its social implications, many real estate investors can be left wondering which strategy to employ. The answer is simple—any or all of them.

ARMs: A Quick Look

Stephon Martin

Adjustable-Rate Mortgages (ARMs) are a viable financing option for both single, multifamily and owner-occupied commercial property owners. Ever since their formal establishment by Title VII of the Garn–St Germain Depository Institutions Act of 1982, ARMs have offered the opportunity to link mortgage payments to marketplace activity. Coupled with the rate collars, ceilings and floors, these financial instruments have the potential to lock in the conditions of a favorable interest rate market, at interest rates that are typically lower than a fixed-rate mortgage. In the world of retail real estate, lower rates can translate into increased purchasing power. For the real estate investor, however, rate fluctuations and potential for sustained above market-rates usually tends to also lead to an early refinance. With the January 3, 2022 deadline for ARMs to decouple from the LIBOR index imposed by Fannie and Freddie, now is an opportune time to take a look at ARMs and their role in the mortgage market.

Property Maintenance Laws and Lending

The fight against property blight is a battle that has been waged for many decades. Some areas of the nation, have struggled with abandoned properties and even abandoned neighborhoods since the shrinking of the nation’s industrial sector beginning in the 1970’s. Other areas became intimately acquainted with blight as a result of the wave of foreclosures that took place at the end of the first decade of the century. However it may have arrived, the real estate finance market is certainly now affected by the palpable concern of property blight and has had to adjust to attempts to mitigate its damaging effects. 

Why Worry About Blight?

To be clear, blight is a real issue that can lead to a number of undesirable effects. Abandoned properties that are poorly maintained cause safety issues. Poorly maintained building systems and structure will eventually fail at some point, causing unsafe buildings. Overgrown landscaping leads to health concerns. These health and safety concerns become a problem for neighboring properties, as neighbors must then focus on how to curb the spread of these issues onto their properties. More generally, well-maintained properties inspire a pride of ownership that carries over to neighboring property owners. The opposite is also true—abandoned and poorly maintained properties drain the neighborhood of pride of ownership and lead to less diligent maintenance throughout the neighborhood.

My How Local Lending Has Changed!

Today's banks are unabashedly international businesses which thrive on providing services and taking advantage of opportunities throughout the world. Long gone are the days of the local Savings and Loan as the provider of the community's mortgage needs. Instead, behemoths of consolidations dominate today's lending scene, thriving off of large economies of scale that make any potentially smaller competitors shutter. This change in the role of banking in the community, although the largely the product of intentional moves by the banking industry and Congress, is not without its effects on the real estate industry, particularly the residential market.

In order to explain the effect of big banks on the residential real estate market, one must understand the role of local banks prior to the expansion and consolidation of banks that led to the current situation. Until the 1980's, US mortgage lending was dominated by small local banks and Savings and Loan Associations (S&L's), local banking entities that engaged in lending and offering savings deposit accounts. Initially, S&L's were heavily regulated and restricted from offering consumer loans and investing deposits in most of the investment vehicles available in the market. The Savings and Loan model relied on a favorable treatment by the Federal Reserve to allow for an increased spread between the rate charged on mortgage lending and the rate offered on deposit accounts. S&L's also frequently managed underwriting risk with local market knowledge.

Monte Carlo Mortgages

In his book Mortgage Wars, former CFO of Fannie Mae, Timothy Howard explains how Fannie's realization that mortgages behave like bonds with embedded call options revolutionized its ability to value its portfolio and manage risk. Prior to this change in thinking, Fannie Mae's methods for reserving capital were consistently shown to be inadequate. Today, the valuation of mortgages and mortgage-related securities as bonds with embedded calls is nothing new.

A call option is a type of derivative, which conveys the right (but not the obligation) to purchase another financial instrument (the underlying asset) for a specified price (the strike price) at a specified time (the expiration date). Purchasing a call option offers the right to purchase the underlying asset and selling a call options impose the obligation of delivering the underlying asset at the strike price on the execution date.

Mortgages are freely refinanceable at any point. In this way, they function as bonds in which the payments from the homeowner serve as the coupon payment and the ability to refinance serves as a call option sold to the homeowner by the mortgage holder. Typically the refinance rates increase as interest rates decrease. Although mortgage prepayment penalties are included in mortgages to discourage refinancing, a large enough drop in interest rates can make refinancing worthwhile to a property owner in spite of the prepayment penalty. For mortgage and MBS investors, prepayments are undesirable. Given that most mortgage investors look to invest anywhere between 5 and 30 years, an early decline in interest rates can leave many investors with cash from prepayments that must be invested in a market offering lower interests rates. This undesirable situation is the double-edged sword of prepayment risk for mortgages.

From Property to Liens and Back

In light of my previous post on timing the market, I thought that I would follow up with a post on one type of investment strategy that takes advantage of the cyclical nature of real estate.

There are a number of ways to invest in real estate. From property acquisition to shorting housing starts to buying equity in a REIT, each type of investment in the real estate market comes with its own idiosyncrasies, which must be understood in order to ensure maximum profitability. Specialization in one category or subcategory is often expected and praised among real estate practitioners and investors. The various entry points into real estate, however, allow for diversification. Purchasing property, notes or securitized bonds provide direct access to the real estate market, while liens, nonperforming notes and real estate derivatives can serve to counteract real estate defaults, if properly purchased. Although, given the change in the regulatory climate for derivatives, real estate derivatives have become more theoretical than piratical.

Since the real estate market has some many points of entry, one can balance a real estate portfolio by investing in different asset classes, depending on the performance of the market at any given time. In this way, an investor can capitalize on the cyclical nature of real estate. One such way to diversify is to purchase property for appreciation and purchase liens and nonperforming notes as the market declines.

Same Mechanism, Different Crisis

I recently read William Seidman's book Full Faith and Credit, which contains a detailed explanation of the S&L crash of the early 1990's that was spurred on by a crash of the US commercial real estate market. William Seidman was head of the FDIC at the time of the crash. A day after I finished the book, I walked by my bookshelf and noticed the book Bull By Its Horns, by Shelia Bair, the chairman of the FDIC during the 2007/2008 financial crisis, when it hit me--both publications are the same book written nearly 20 years apart. Although each of the authors have their individual differences, they are both similar in that they were Republican chairmen (or is the term chairpeople?), serving during Republican presidencies, who presided over the fallout of a banking crisis that resulted in the largescale nationalization of private assets and companies.

The political affiliation of both former heads of the FDIC is tangential to my point, however, I mention it to make two observations. The first observation is that both Mr. Seidman and Ms. Bair are linked by political party. The second is that the economic climate forced them to participate in the goverment takeover of private companies and their assets, an idea that is antithetical to most Republican ideology.

Although one of the chief duties of the FDIC is to close failing institutions and liquidate their assets, under most normal economic circumstances, this duty of the FDIC is either carried out infrequently or confined to a certain sector of the market. Both the S&L crisis of early 1990's and the Great Recession of the late first decade 2000's, however, forced the FDIC and other government agencies to either take ownership an stake or fully national financial institutions in a large, systemic manner.

Mortgage Backed Securities and Personal Bankruptcy

At long last, the end of the series!

Personal bankruptcy is usually filed by an individual for very different reasons than corporate bankruptcies. Whereas the primary motivation behind filing a business bankruptcy may be protection of the business or satisfaction of debts, personal bankruptcies are frequently filed for asset protection, in addition to satisfaction of debts.

The two sections of the bankruptcy code that apply to personal bankruptcies are chapter 7 and chapter 13. As with business bankruptcies, chapter 7 for personal bankruptcies is a process of liquidation and seeks include all non-exempt assets of the petitioner in the bankruptcy estate in order to liquidate them to pay off debts. Chapter 13, on the other hand, seeks to reorganize the debt of a petitioner pursuant to a payment plan, which typically last from 3 to 5 years.

Special Purpose Entity Bankruptcy Concerns for Mortgage-Backed Securities

Let us continue the bankruptcy theme begun in my last post and discuss the effects of Special Purpose Entity (SPE) bankruptcies and their effect on mortgage-backed securities. Obviously, most bond covenants designate the bankruptcy of a SPE an event of default and restrict the likelihood of its happening. In the unlikely event that such a bankruptcy does happen however, here is an overview of the process.

As a quick review, I would like to restate that mortgage-backed securities are the result of a process of securitization that takes place when a real estate lender sells a package of its loans to an entity, called and SPE. The SPE receives the money to purchase the loans from the sale of either securities, beneficial interests in the entity or trust certificates from a trust set-up to hold the loans. If securities or trust certificates are sold, they are called mortgage-backed securities (MBS). Through the securitization process, real estate lenders are provided with cash to originate more loans and investors are able to purchase MBS and invest in the real estate market without having to hold real property. If you question why one would want to invest in the real estate market at all, please see my earlier post, “Why I Choose Real Estate.”

Lender Bankruptcy and Mortgage-Backed Securitization

Mortgage-backed securitization is an essential part of the mortgage secondary market, as it provides both liquidity and expanded sources of funding for real estate lender. Securitization also allows for more widespread participation in the real estate market, since MBS bonds are an asset class that can be held by classes of investors that are restricted by law from retaining extended ownership in real property. More participation in the real estate secondary market, of course, translates to a more robust market with more available real estate funding and more real estate activity.

Despite its role in the market down-turn of 2007/2008, securitization of real estate assets has been and continues to be an important part of the U.S. real estate finance market. Securitization, however, heavily depends on a bankruptcy remote structure.

Second Mortgages: Why They Are Less Prevalent In Commercial Real Estate Than In Residential Real Estate

Early in my whole loan trading career, an investor once offered to fund a partnership that would purchase second position liens, also known as second mortgages, secured by commercial real estate. The investor promised to pledge a substantial amount of capital, if I was able to assemble a portfolio of target assets. Understanding the risk/reward profile of such an investment and desiring to deliver for what seemed to be a potential source of new business, I quickly began to work on finding commercial seconds to underwrite and select. After a few days on the phone with a number of commercial lenders, real estate debt funds and large financial institutions, I began to realize that commercial real estate second mortgages were not easy to find. Finally, after a few weeks of searching, I informed the investor that I was unable to find any asset worth purchasing that met his mandate.

Nearly ten years later, I now understand why the second mortgage, an established method of financing in the world of residential finance, is so infrequently used in commercial real estate. To state it plainly, the property-income focus of commercial real estate, makes commercial seconds more of a liability than an asset. It is this income focus that leads most commercial lenders to emphasize property performance over the qualifications of the borrower. As a result, most commercial financing is offered with no recourse to the buyer upon default, giving the lender as much control over a distressed asset as possible and incentivizing the owner of a distressed property to “walk away” when there are no more options. In order to maintain as much control over the property as possible, most commercial real estate lenders will insist that they be on the only creditor of the property and that the property be structured in such a way that it is remote from the bankruptcy of the borrower. These goals are typically accomplished by establishing a holding entity for the property to be financed, placing the borrower in the equity position of the entity and making the lender a creditor of the entity, secured by its largest asset.

Lender’s Fees: How Should One Account For Them?

Lender’s fees are a fact of life in real estate acquisitions. I was recently reading a chapter in a real estate handbook that outlined the justifications of a number fees commonly associated with mortgage origination and it offered a number of options for reducing their amounts. The relative negotiability of each lender fee, however, depends greatly on the lender, the credit worthiness of the borrower, the size of the asset, the size of the down-payment and market conditions. Generally, the stronger the buyer, the larger the asset and the larger the down-payment, the more negotiable lender’s fees are. Below is a discussion of some of the most common lender fees and how to account for them.