When I purchased my first home, the closing agent gave me the first three payment coupons for me to make the payments until the lender sent me a payment coupon book. I didn’t need the first one. Within two weeks I received a letter in the mail that stated that my loan had been sold to a new lender. Overall, the loan was sold four different times. I understood what was happening because it was my job to originate and sell marketable loans, but borrowers and real estate investors aren’t clear about the process that takes place in originating an servicing a loan.
When most people want to buy a home, their first thought is to call their bank to get a loan. Houses, however, are high-ticket items. According to the Mortgage Bankers Association, the average new mortgage in the United States was about $355,000 in the first quarter of 2019. Banks have a lot of money…but not that much money. They would soon run out of cash is they continued to issue 30-year mortgages. In addition to running out of capital, they would be subjecting themselves to tremendous interest rate risk by making long-term, fixed-rate mortgages in a changing interest rate environment.
As a solution, the Mortgage Backed Security (MBS) was born. In order to fund large amounts of fixed-rate, longer-term loans, conservative investors would purchase a portion of a large pool of loans. The investment works a lot like a bond where an amount is invested and then a fixed payment is received back to the investor over a longer period of time. Let’s say that a pool was created with several thousand 30-year, fixed-rate loans in it. The investors would receive periodic payments that would represent a return of their capital plus some interest as the borrowers paid back their mortgages. Government Sponsored Entities (GSEs) such as Fannie Mae and Freddie Mac were created to facilitate and standardize loans that entered these pools to better ensure that consistent quality assets were entering pools. Higher-yield, subprime MBSs were created to facilitate a market for borrowers that might not qualify for the more stringent standards of GSEs.
Most 30-year fixed-rate residential mortgages that are originated today in the United States today end up in an entity created specially to house a large number of similar loans. These “traunches” are funded by Mortgage Backed Securities (MBS) that are offered to conservative investors. When a bank, mortgage lender, or mortgage broker originates one of these loans, they are sold into one of these traunches. The traunche then has a Servicer (discussed shortly) handle the loan for them.
Many larger commercial loans with longer terms often end up in a traunche that is backed by Commercial Mortgage Back Securities (CMBS). CMBS loans often have terms of longer amortizations (periods in which the payments are calculated on) and are often offered on properties that depend on rental streams to pay back the loan. Properties such as retail centers, office buildings, and apartment complexes are often funded through the CMBS markets. Many are also offered on a “non-recourse” basis, meaning that the loans are not guaranteed by the person that owns the borrowing entity. Recourse means that if the borrower, usually an entity like an LLC or a corporation, does not pay, the lender can go after another party (usually the person or people that own the borrowing entity) for the payments. A non-recourse loan means that the owners of the borrowing entity have no liability to pay the loan back in case the borrower defaults. Most banks will only do non-recourse loans for publicly traded companies, non-profit entities, and larger very special customers, but non-recourse loans are more commonplace in the CMBS markets.
Banks operate a bit differently. Banks don’t always sell their loans. As a matter of fact, most types of loans they would prefer to hold on to. Banks are constantly walking the tight-rope between having enough available capital on hand to lend when they need to and having enough capital deployed to borrower to collect enough interest to make the net profit that they desire. That balance often determines what a bank holds on to and what they sell.
Interest rate risk is something that banks are always concerned about. Banks “cost of funds” is what the bank pays for the cash that they use to lend out. That cost of funds goes up and down with interest rates, so locking in a long-term fixed-rate when their cost of funds varies could leave a bank in a very bad position. Normally, banks will hold on to loans that have terms of 5 years or less while they will tend to sell the loans that have terms that are longer than 15 years. Banks have decisions to make when it comes to loans that have terms in between 5 and 15 years with respect to whether to hold the loan on their books or whether to sell it off. Much of that decision comes from the relationship that they have with the borrower.
The general public tends to think that Banks make all of their money from loan interest. That isn’t true. They make a great deal of revenue from other fee income they gain by building deep relationships with strong clients. Banks make revenue from large deposits that a client holds, they collect fees from treasury management services, and customers pay fees for investment portfolios they might hold with the bank. There are many revenue streams that a bank collects and they don’t want to jeopardize those streams by selling off loans that they make to good clients.
Most banks will hold on to their commercial loans, consumer home equity lines of credit, car loans, and other types of personal loans. They will typically sell, however, long-term consumer mortgages. What they keep and what they sell largely depends upon their overall relationship with the borrower, their capital position, and the interest rate risk that they would have to absorb by holding on to the loan.
Many banks that have larger infrastructures also have the resources to keep their own collection payment teams on hand. “Servicing” a loan is the function of sending out statements, collecting payments, making collection calls if need be, and doing all of the other things that are required after a loan has been made. Hedge funds and Wall Street funds that own loans almost always use a Servicer to collect their payments. Servicers will be discussed elsewhere in this book, but the law does require the use of licensed servicers in many instances. Banks are allowed to handle their own servicing, but often choose to have someone else do it for them. They retain ownership of the loan, but they might pay a Servicer a fee to handle the servicing function for them. Mortgage companies typically also hire a third party servicing company to service their loans. The traunche that we discussed earlier might own the loan, but the payments are made to the servicer who collects a small fee and then forwards the rest to the traunche.
One advantage of the MBS and CMBS markets are that their loan paperwork and underwriting are often standardized across the industry regardless of who makes the loan. This makes selling loans easier. If you take a bill out of your wallet, you’ll notice the word “note” on it. Well, the loan document that obligates the borrower to pay the loan back is known as a “note”. It is a “negotiable instrument” that may be transferred from owner to owner easily. When the loan adheres to generally accepted, confirming guidelines, then the loan is more negotiable than a loan that doesn’t conform to industry standards.
One of the primary goals of this book is to make you aware of how you can “become the bank” by purchasing marketable loans. Understanding how banks, hedge funds, and Wall Street traunches trade their loans is critical if you want to inject yourself into the process and purchase loans or REO property on your own or for funds that you manage. Once you understand the process, it opens up a whole new way of obtaining real estate and real estate backed assets to grow your empire.