Reinstitutionalizing Equity-Based Lending, part 1 By Lane T. Bacon

by 01 Sep 2008
An efficient process and proper methodology of re-institutionalizing equity based lending amidst the Credit Crunch is the focus of this article. First, I must define 1) equity based lending, and 2) what qualifies as ?institutionalized? in today?s market. Equity-Based Lending (EBL), a derivative of Asset-Based Lending (ABL), is simply summarized as lending and underwriting based upon the remaining equity in the collateral after the new loan is secured. For an ABL situation, the typical average Loan-To-Value (LTV) is less than 60%. An example of the process would be a borrower in the foreclosure process. Their existing loan has an Unpaid Principal Balance (UPB) of $200,000. Back interest and fees have added another $20,000 to the borrower?s obligation. Based on a new valuation; the collateral value is $500,000. An equity based lender would be able to make a new loan for up to $325,000 to save the asset from being sold at foreclosure and to recapitalize the borrower. Traditionally, ?institutionalized? meant the acceptance of the secondary market, securities market, and ultimately an appetite from bond investors. With a near complete void of private issued Mortgage Backed Securities (MBS), the traditional definition seems antiquated, if not dead altogether. However, within the asset-based market ?institutionalized? has also been defined as making financial instruments part of a structured and usually well-established system ? replacing the previous fractured market system in which assets within this category were often valued individually and without a systematic, repeatable and logically defensible methodology. A structured and well-established system is at the core of a professional organization and fund operation; and forms the basis for a new secondary market for equity based lenders and new investment vehicle for investors looking to maximize their returns. . Traditionally mortgage loan financing was the purview of banks and savings and loan institutions who lent to borrowers with strong credit and enough cash or existing equity to provide sufficient protection to the lender in the event of trouble. Most of these lending institutions were portfolio lenders and the secondary market was dominated by government sponsored entities (GSEs) such as Fannie Mae, Freddie Mae and Ginnie Mae. These GSEs were also portfolio lenders, but also created a secondary market of Mortgage Backed Securities (MBS) that were available to institutional and private buyers. Prior to 2003, 70% of all MBS issues were done by these GSEs. For homeowners with less than exemplary credit, the borrowing market was very limited and suffered from almost a back-alley reputation. Equity-based lending at this time was known as ?Hard Money?. Lenders were almost exclusively private individuals and the market was extremely fragmented and locally based. Borrowers often waited months to close a loan as investors evaluated properties individually, and only invested one property at a time. Diversification was an uncommon situation with most private lenders only investing in properties within driving distance. However, over the past fifteen years, lending standards expanded and more innovative mortgage products were developed. As this occurred, the private mortgage market grew exponentially and new business models developed. Institutions such as Countrywide, New Century and Option One came into the marketplace. Homeowners who previously had limited borrowing possibilities found themselves with multiple options as well as the ability to obtain financing at higher levels. Alt-A and Subprime lending grew exponentially. Spurring the growth of these new players was the explosive growth of the secondary MBS market. Attracted by the returns and spurred on by the strong increases in housing values, institutions snapped up bond offerings as fast as they were issued. These securities are commonly referred to as ?private-label?. At the peak of the private label/ issued MBS market in 2006, 55.9% of all MBS were originated by parties other than GSEs. However, with the disruption in the credit markets in late 2007 and depreciating house values, the private label mortgage backed securities (MBS) market has all but disappeared. Many investors in the MBS market have taken substantial losses due to lower house values, which resulted in decreased confidence in the credit markets. William R. Evans, an officer and economist at the Federal Reserve Bank of St. Louis, estimates private label MBS market share will be reduced to less than 10% of the overall market. The result is a void of institutional equity based lenders or hard money lenders which provide financing options for distressed companies and individuals who own commercial or residential properties. The opportunity is for a new business model that allows borrowers with significant equity access to money while providing investors with attractive above-market returns while providing the protection of diversification and standardized valuation safeguards. Addressing Complacency Clearly, throughout 2003 ? 2007, lending standards were loosened beyond reasonable standards and investors took the brunt of the losses stemming from the poor underwriting standards of most lenders. During the years leading up to the Credit Crunch, investors? appetites for bonds from Mortgage Backed Securities (MBS) were nearly insatiable. Pools of loans were being sold at substantial premiums to the Unpaid Principal Balance (UPB) remaining on the loan. Sale premiums exceeding six percent (6%) were not uncommon and four percent (4%) was considered normal. Mortgage companies and intermediaries relaxed guidelines in order to increase production and realize more gains. Zero and limited documentation loans became prevalent. Interest only loans and loans with teaser rates far below existing benchmark rates became widespread. Minimum credit requirements were lowered, and under Alt-A and Subprime lending guidelines, the amount of a down payment, or owner?s equity, dwindled to nothing. The result was an increase in eligible borrowers and thus a substantial increase in the demand of real estate, thereby driving up property values at rates never before seen. The rise in real estate values and historically low default rates prompted rating agencies such as Standard & Poors, Fitch, and Moody?s to assign high investment grade ratings to many of the bonds being sold through the MBS market. With the superb ratings, bond insurers, such as AIG, MBIA, and ACA Financial Guaranty, often insured billions of dollars in bonds. The mortgage originators and intermediaries passed the risk of loss to the investors purchasing and insurers insuring the bonds originated via the MBS, e.g. the originator and intermediaries had zero vested interest or ?Skin in the Game? of the performance of the loans in the securities. Threats to Property Owners Historically, many property owners have been able to fend off foreclosure during the publication period (the time frame from original Notice of Default, NOD, to foreclosure Sale ? typically 120 days). Often, borrowers had been able accomplish this by tapping equity in eleventh hour through loans offered by equity based lenders. Rates and fees are often high on these loans; however these loans were designed to be a bridge or conduit to provide time for the borrower to do one of two things; 1) access sufficient capital for the owner to recapitalize their business or finances in order to stabilize their income stream, or 2) sell the property, satisfy the outstanding mortgage debt and realize their capital that would otherwise be locked in their equity. If the mortgage marketplace fails to re-institutionalize equity based lending, many borrowers, who would normally stave off foreclosure through a ?one last chance? loan offered by an equity based lender, would fall victim to the Credit Crunch and lose the capital locked in their property?s equity. Problem Statement Due to the seizure in the credit markets, many equity based lenders have not been able to liquidate their current positions, thus greatly suffocating their capacity and throughput, or in many cases driving the lenders out of the market or business completely. The result has created an underserved market of businesses and individuals seeking financing secured by real estate, e.g. a competition free marketplace for equity based lenders now exists. The problem is twofold, in that we must 1) create a business model to efficiently originate equity based loans while mitigating the liquidity, interest rate, depreciation, and default risks associated with the cause of the Credit Crunch and 2) create an investment vehicle with sufficient capacity to serve the marketplace in a meaningful manner.


Should CFPB have more supervision over credit agencies?