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Clint Hinman is the Editor of the NoteWorthy Newsletter (click here to subscribe or call 800-487-1864).  You can read his blog here.

The last of the securitizers has left the building. Some went out in a blaze of gory (misspelled intentionally), and others quietly slipped out the back. The industry has come full circle to a place where purchase yields matter again, and due diligence is no longer perceived (at least by the investor) as a nuisance designed to thwart purchase volume.

From the first seller-financed securitization in 1996 to the last in 2007, the industry had a ‘golden age’ of 11+ years that made many brokers (and investors) wealthy. Pricing was at levels never seen before. Underwriting standards got more and more inconsequential as Wall Street money got more and more plentiful. A relatively small and previously unnoticed niche market consisting of privately held real estate notes was enjoying equal billing with the big boys of conventional lending.

The securitizers liked this paper because it was discounted. Discounted paper meant immediate profits to the issuer when the securities were sold off to investors. Even though some of the notes were written at relatively low rates, any good securitizer knew to mix in some high-rate commercial and subprime loans and the weighted coupon still allowed the bonds to be sold off at par. Based on the performance of the bonds, the securitizers also stood to reap rewards on the backside as holders of the non-rated, or equity tranches. (To give you some idea of how highly regarded the equity tranches were to the traders, they were also known as “first-loss”, and later, “toxic waste”.) Some securitizers even leveraged their positions in the equity tranches by selling instruments known as CDOs (Collateralized Debt Obligations). This allowed them to realize even more cash upfront and the investors who bought the CDOs were then in the catbird’s seat to make the big returns. Unless…well, unless enough loans went into default…which is exactly what happened.

Not only were the equity tranches sold, but other exotic instruments with names like NIM (Net Interest Margin) and PSA (Pre-Payment Speed Assumptions) were as well. Anything that could get the issuers cash on cash today was sold. When delinquencies and defaults started wiping out the equity, and even mezzanine (mid-rated) tranches, the CDOs became worthless, and unsuspecting investors (remember, nothing can go wrong until it does) were shellshocked by the magnitude of their losses. The domino effect continued from there, tarnishing even the senior (AAA-rated) tranches and ultimately paralyzing the entire RMBS (Residential Mortgage-Backed Securities) market.

Coming full circle, though, is a good thing, right? Back to the basics, Keep It Simple Stupid, Pick the low-hanging fruit, blah blah blah, all the old clichés succinctly redefine our approach, don’t they? Ah, but here are some things securitization created that complicate matters:

1) Market or Below-Market Interest Rates – Seller-financed paper once demanded an above-market interest rate in exchange for the risk (and often the inconvenience) the seller took by holding the note. Securitization made yields an afterthought, so sellers could still get mid-90’s pricing on rates as low as five and six percent as long as the rest of the deal looked good. Now those five and six percent notes see pricing in the 60’s and 70’s and sellers scoff at the reprehensible notion they would absorb such a huge discount in order to sell their note.
2) Individual Deal Merit – Historically, every deal had to stand on its own. Securitization allowed portfolio sellers to throw in a few lousy notes as long as the majority were strong from an underwriting standpoint. The high LTV, poor-credit notes on the market today are no longer even saleable. At best, an investor may offer a partial, pricing to a yield commensurate with the risk. Again the sellers recoil in horror at the discount.
3) Rehab Market in Flux – The securitizers’ thirst for product could only be satiated by the creation of new product, and the simultaneous closing was born. Table fundings became commonplace: Depending upon how certain securitizers’ attorneys viewed the lending laws, the “simo” and the “near-simo” churned out product to feed the machine. Real estate investors saw the ‘simo’ or the ‘near-simo’ as the perfect vehicle to buy low / sell high (aka flip) properties and make a profit with no liability or risk in the transaction. Only securitization allowed this model to flourish, and when the market paralysis struck, ‘simo’ became a different kind of four-letter word. Buy-and-sell investors were forced to seek private financing, hold and service the notes they created themselves, or hope the buyers of their properties could qualify for FHA financing.

Estimates vary, but only about five to ten percent of the volume of paper being traded during the securitization years is being traded today. Using logical deduction, only five to ten percent of commissions are being paid out now versus the prior ten years. The silver lining, of course, is that as conventional lending standards constrict, more sellers must offer financing as a way to induce buyers to buy. The expectation of unlimited seller-held paper for the future must be tempered by the actualization of fewer total properties being sold presently as opposed to years past.

This industry is resilient. Creative people find creative solutions to the barriers placed in front of them. This has never been a get-rich-quick business and it never will be. An ability to adapt to a constantly changing landscape is paramount. A lot of people made a lot of money during securitization’s heyday. There is still a lot of money to be made in today’s market, but the approach must be entirely different. Finding private investors, using IRAs to buy for one’s own portfolio, learning the intricacies of alternative cash flows (partials, fractionals, split-payments, etc.), how to sell them, and who buys them are the new rules of the game. Still care to play???