The Sub Prime Continuum Theory

Let’s define the following first

Sub Prime -Less than prime; credit with higher risk characteristics thus charged a greater rate of interest, such as bankruptcy or collection accounts or also called B&C credit.

Continuum - A sequence in which variation in vegetation and/or properties between one event and the next of the series is continuous rather than discontinuous.

Theory - a tentative insight into the natural world; a concept that is not yet verified but that if true would explain certain facts or phenomena; "a scientific hypothesis that survives experimental testing becomes a scientific theory."

The Sub Prime Continuum Theory states that people who have managed to find themselves with a B & C credit rating will always engage in fiscal irresponsibility not always to their fault but it is partly because of the credit risk assigned to them. In the current world we live in everyone’s ability to re-pay a debt is based on the FICO (Fair Isaac Credit Organization) which causes a viscous circle once there is the first sign of trouble. It begins once you go from A+ prime credit to B/C sub prime credit; the reason for losing your prime status has no bearing no matter how valid of a reason it is. Once a person’s status has changed from A+ prime to B/C sub prime life will change and the cycle begins.

One of the unspoken mentalities that the B/C sub prime candidates carry with them is the idea that there credit will never be the same again no matter what they do. This rationale is dangerous to both creditor & consumer; the best way a creditor can collect on a debt is to threaten to harm ones credit rating if that credit rating is already negative than the creditor has lost its most valuable tool in recouping the credit it extended. The consumer on the other hand views there new B/C sub prime status as a new reason not to have to be as attentive in regards to their bills due date. This newfound attitude is the start of the sub prime continuum theory.

The theory focuses on reasons that individuals representing the B/C sub prime credit tier maintain that status. Consumers classified as sub prime pay more for the same goods that prime credit consumers, this holds true to everything including mortgages, insurance, credit cards, lines of credit, financing household goods, business loans, vehicle loans, & even cell phones. The difference between a sub prime mortgage on one hundred thousand dollars and a prime mortgage can be as much as six percent or five hundred dollars a month higher. That may seem correct based on the creditor taking on more risk with a B/C sub prime borrower but many times it has the opposite effect. Does it really make sense to require the individual who has demonstrated a difficulty in paying his/her obligations to give them a five hundred dollar higher monthly payment then the prime consumer? I do not disagree that the creditor should hedge additional risk with greater reward, but I think there is a way to do this without damaging the consumer’s ability to perform on the note on a monthly basis.

Obviously the creditor is helpless if the consumer decides to not pay the note, but there are ways of limiting theses occurrences. First of all is not to differentiate A+ prime credit from B/C sub credit from a monthly debt servicing perspective (interest rate) and implement a different method of collecting the reward for increasing the risk; one suggestion would be to take on a fee for consumers who are not credit worthy. This fee would not be pre-paid and not be calculated in the balance so that interest does not accrue on it. This said fee would be fully earned when the account is paid off or closed and by implementing monthly payments on the fee at zero percent once the balance is at zero and the consumer/creditor does not wish to extend out the credit again. The fee also can be modestly increased/decreased depending on current payment history; it is a risk/reward system. This fee would enable B/C sub prime credit consumers to realize the same debt service ratio’s as the A+ prime consumer thus increasing the creditor’s chance at recouping the credit extended and interest earned on that credit in a timely manner; while not losing out on taking on additional risk.

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Creating a profitable commercial lender in this market

This is a conceptual idea on how to create a profitable commercial lender while protecting all parties involved. There are four separate groups that would need to be aligned to make this work but if you were able to put all four together it would create large revenues for each one. The four parties that need to be aligned are:

Commercial Lender- Take in the transactions from a retail perspective, validate transaction through due diligence, writes the loan and table fund it. Generates fee revenue at closing & YSP from the sale of the loan.

LC Provider- Would provide the credit lines to the Commercial Lender, generates profits from loaning out funds on short term basis

Insurance Company- Insure the loans AA or higher rated, generates profits from the premium collected

Loan Servicer- Services the loans and generates profits from YSP and interest collected

Here is a more detailed description of the process:

The objective to both the LC lender, and the mortgage company is to create a profitable business relationship. The LC lender can make secured credit (or lines) available to the mortgage lender thereby enabling the funding of approved high return mortgages that have been underwritten according to stringent guidelines including “double-value-collateral.” The mortgage company will be able to generate substantial origination and resale income plus profitable spread on each mortgage enabled by the LC line and pass along the agreed upon share of those profits to the LC Lender.
Servicing the Note: All loans made against the LOC will be structured as a 12-24 month balloon note. The first 12 months of interest are withheld from the loan at rates between 15%-18% and are held in the mortgage company’s account to service the loan until it is sold. The monthly interest that the mortgage company escrows will be equivalent to the entire term of the note at the cost of carry.

To make the LC lender secure, it must have four items pledged and/or managed for it:
1. A marketable first lien mortgage in which it can obtain unrestricted title.
2. The mortgage to be either
A) Pre-sold to a permanent mortgage investor limiting the time exposure and transferring any risk from the Mortgage Lender (and by function, the LC Lender.)
B) Portfolio positioned during a brief period of CONTRACTED and BONDED collateral enhancement and/or loan pre-refunding. Collateral enhancement means improvements to the property that significantly increases the market value of the first lien mortgage. Loan pre-refunding which means cash moving into escrow securing the first lien mortgage due to Bond or Bond Anticipation Note issuance thereby DRAMATICALLY increasing the market value of the first lien mortgage.
3. Complete control of the funds via Title Escrow on the sale to the permanent investor on pre-sale transactions (A above;) or strict Loan To Value funding adherence on land collateral and bonded developmental improvements on portfolio positioned transactions (B above.)
4. Escrows of Interest due the Mortgage Lender on each loan made enabling sure funds for the servicing of the LC/Monthly Note.
Please Note: The loans are approved prior to funding and specific closing instructions are given to the title companies instructing them to close the loan only when the mortgage is a first lien with a good and marketable title.

Pre-sold loans– Loans that the mortgage company has identified and secured a buyer for prior to funding.

1. The key is to identify current issues in commercial paper market
a. Shortage of buyers of loans
b. Most lenders do not portfolio
The mortgage company’s solution is to insure commercial paper to create high yield guaranteed paper. AA or higher insurance rating opens up an entire new group of buyers eliminating liquidity issues that exist in current commercial market. The mortgage company will now be selling insured paper with added value feature of first lien position and the mortgage company should yield a higher premium for the additional benefit.

2. Due to the buyer being identified prior to funding the loan and due to the price being set, the mortgage company maximizes revenue on the transaction and draw down time would be kept to a maximum of 72 hours.

3. Insured paper brings stronger buyers to the table that are very liquid and have infrastructure in place to service the loans-therefore providing a quick close. Current commercial buyers utilize short term notes where insured paper buyers purchase longer term debt thus creating a better range of products to offer borrowers and structure higher IRR for the mortgage company.

4. Insurance policy covers investors’ loss in the event that the loan defaults and redeeming the foreclosure does not satisfy payoff. Insurance policy is leveraged to cover difference to provide full payment to investor. Premium cost is passed through to borrower as a closing cost, thereby not diluting the mortgage company’s profit margins.

Portfolio Loans– Loans for development purposes that are Municipalities or Municipal Issuers and can issue tax-exempt debt. The mortgage company is only putting loans in our portfolio where the Borrower controls both sides of transaction such as an improvement district: Borrower owns the collateral and controls municipal debt. This occurs when municipal issuer benefits greatly by the development of its infrastructure within its boundaries. A Development loan backed by a large amount of cash subsequently place in escrow from a follow-up municipal financing trades at a high premium due to cash.

1. This unique scenario creates an opportunity to mimic a bond pre-refunding type of transaction. A development project that has amassed a large amount of cash and has municipal debt outstanding trades at a high premium due to cash reserves backing the bonds. The mortgage company will structure the development loan so as to benefit as the bond re-imbursement proceeds flow in; this enhances the creditworthiness of the loan increasing market value.

a. The mortgage company Portfolio Loans are cherry picked and only the best of the best will be put in the portfolio limiting these transactions to between one & two loans per annum.

2. The loan is saleable at any time. We are purposely holding the loan to allow the Note value to continue to increase from development of project and to escrow bond proceeds. At which time, the Note can be a sold at a premium, much higher than the cost associated with holding the loan in portfolio.

3. MAC Clause (Material Adverse Change) Clause. This feature will be included in the loan design and documentation. It assures that if the LOC is revoked, the security instrument is subject to call and the mortgage company will have the ability to escalate nominal interest rate in order to get loan sold. This will also shorten the term because the new rate will deplete interest rate reserve quickly. The MAC clause can be removed at time loan is sold at buyers’ option but it is an enhanced safety feature for end investor & LOC provider.

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Debt vs. Equity Financing

What is the real difference between Equity Financing & Debt Financing?

By definition debt financing is: When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay principal and interest on the debt.

By definition equity financing is: The act of raising money for company activities by selling common or preferred stock to individual or institutional investors. In return for the money paid, shareholders receive ownership interests in the corporation.

Debt financing is what I like to call collateral intensive and is backed by the credit of the individuals/businesses that are borrowing money. This makes it challenging in today's credit market for businesses or projects to get funded. The need for borrowing money is because the individuals/businesses do not have enough capital to accomplish there goals. That being said since these types of financings are demanding what these individuals/businesses lack "collateral" it always seems to me strange that this is always the first place that individuals/businesses look for money. One reason for this is because individuals/businesses do not know any better they are under the impression banks are there to make loans. This is partially true, banks borrow money at short term floating rates and then loan that money out to consumers at much higher rates than it costs them to borrow. Banks need collateral for this reason to protect the money that is lent out since they are lending out borrowed funds. They almost never value collateral properly it usually undervalued for their benefit and since they have the money they must be right. This is why they are not the right institutions to borrow funds from.

Equity financing is much different from the above; while equity financing can take many various forms there are some underlying themes that remain the same. We are going to talk about the private placement market right now; the private placement market is one of the best methods of getting your business/project funded in this current economic climate. The main reason is due to who is buying these private placements. Life insurance companies and pension funds are the largest buyers of private placements they do not borrow money they take in cash deposits from retail consumers and they do not keep that money idle. They have the ability to keep their investments out for longer time frames earning on a modest rate of return, this is a huge advantage to the Individual/Business that it is invested in since banks do not like to loan out funds for long durations. Also since there are covenants written into the loan documents that in a debt financing transaction can not be broken or you are in default it makes it extremely challenging to change anything after the fact. On the contrary in private placementsthose covenants are expected to be broken and it is acceptable as long as it benefits the overall project/business.

What is a better method of funding? I will leave it to the eye of the beholder.

An excellent study was done by the Federal Reserve and can be downloaded here.

http://www.federalreserve.gov/pubs/staffstudies/1990-99/ss166.pdf

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