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Sub-prime lending rises from the ashes

Sub-prime mortgages blew a $2trillion hole in the US economy and caused a worldwide meltdown in financial markets, stopping just short of igniting a second Great Depression. Well guess what – sub-prime lending is alive and well again in the US.

OK, I’m getting a bit ahead of my story but mortgage companies on this side of the pond are once again making real estate-secured loans to citizens with poor credit scores. But this time there’s a catch – these aren’t your sub-prime loans of the past decade.

First off, the new breed of lenders do not consider themselves sub-prime originators at all. They prefer the phrase ’hard money’ because it represents loans made to home owners or buyers who have a hard time getting mortgages elsewhere.

And there’s something else you should know – the dollar volume of the loans being funded today is miniscule compared with the mortgages that were funded during the go-go noughties.

In 2006, at the peak of the sub-prime market here, roughly $800bn worth of Ato D-rated loans were funded. In 2010, $1bn at best will be originated in hard money loans.

But if volumes are tiny, profit margins are through the roof. For example, take a look at some of the recent loans made by Excelsior Management Group of Oregon. EMG is managed by mortgage industry veteran Rick Baldwin whose family has been in the business for almost three decades. On average, notes originated by the company carry yields of 12% with five points. No – that’s not a misprint.

And as for the risk factor inherit in the loans, Baldwin isn’t losing much sleep. EMG’s maximum LTV ratio is 65% which means if a borrower doesn’t pay up the company can seize their house and sell it, more than recouping its investment.

In the noughties it wasn’t unusual for high-flying sub-prime lenders such as Countrywide, Ameriquest and First Franklin to make loans with LTVs of 95% to 100%.

So in short, the companies making hard money loans in 2010 are conservative. They carefully underwrite their loans, analysing everything about a borrower’s finances and ability to pay. Of course, this is precisely what the sub-prime business was all about when it was born in the 1960s.

For several decades hard money – or sub-prime – was a small but profitable niche until Wall Street stuck its claws into it. You’ve heard my rant on this subject before so there’s no point telling you again how badly the Street screwed up the business.

Anyway, the good news about the new sub-prime is that it’s profitable and appears to be well managed and safe. The bad news is that although it sounds pretty good on paper this specialised sector is not poised for a boom, although for some lenders at least it’s a way to make a living while house prices slowly rise from the depths.

In 2006 $800bn worth of sub-prime loans were funded. This year $1bn at best will be originated

All the firms playing in the space are non-banks. Their financing typically comes from private investors who do not care to be named – most are wealthy individuals. Some money comes from investment clubs or hedge funds looking for a high return on their cash.

One firm making hard money loans in California is Calcap Advisors of Pasadena. Its chief executive officer is Mark Mozilo – son of Angelo Mozilo, whose Countrywide venture became the poster child for the whole mortgage crisis.

In fairness to Mozilo senior Countrywide was one of the most respected lenders in the country for 30 years until it entered the sub-prime space in the late 1990s. Sub-prime was clearly Countrywide’s undoing.

Mozilo junior takes a sober view of the hard money business. As with Baldwin’s EMG every loan is carefully reviewed and underwritten, with LTVs no higher than 60%. In his 40s Mark has worked at several ’A’ paper lenders, including his father’s firm which is now owned by Bank of America.

Calcap is roughly two years old and has made but 20 loans. Lately it has been charging 10% on its mortgages with two points upfront. Finding investors to front him money appears to be no problem for Mozilo. Wealthy Americans realise that if they lend money to Calcap they can earn returns of 8% and up.

Will this nascent rise in hard money lending one day blossom into something bigger? It’s doubtful that hard money volumes will ever equal the sub-prime production of the 2000s but as Baldwin points out – thanks to the downturn, the job losses, and everything else that goes with an economy in ruins we now have more non-prime borrowers than ever before.



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