by Ramsey Su
As long as real estate value appreciates, any system will work, even sub-prime. It is when value depreciates that all the flaws are exposed. There are misguided efforts in the works, supposedly intending to correct these flaws. The most notable are the CFPB's (consumer financial protection bureau) mountains of worthless red tape and the Corker/Warner proposal for phasing out the agencies.
This post discusses the most basic terms in real estate finance – recourse or non-recourse.
Think of real estate financing as a real estate investment partnership between two partners, the borrower (B) and the lender (L). There are two types of partnership: recourse and non-recourse. When property value appreciates, the two types of partnership are identical. The B partner receives all the appreciation, while the L partner receives the original principal plus interest.
When the relationship turns sour, usually due to default by the B partner, the two types of partnership cannot be any more antithetically different. When massive numbers of B partners default due to declining property values, all hell breaks loose.
Under a non-recourse partnership, the burden is on the L partner, who can only seek recovery from the collateral. Underwriting standards should emphasize the collateral. For example, if the borrower is looking for a $50,000 loan against a property that is worth $100,000, it is irrelevant what the borrower's income is, or some random FICO score. This is a good loan. It is a much better loan than, say, a 90% LTV loan to highly qualified borrowers, who always have the option of strategic default if the property value falls below the loan amount.
On the other hand, in a recourse partnership, the burden is on the B partner, who is liable to the L partner for any loss. In this case, the lender couldn't care less if the LTV is 100%, 150% or higher, as long as the borrower has the ability to pay. The property is not much more than a cushion if unexpected hardship falls upon the borrower.
Taking it a step further, the underwriting can be fine-tuned. For example, in a recourse partnership, if say the borrower is a heart surgeon in his early 40s, with over 20 years of high earnings potential ahead, the lender is happy to extend a loan against that stream of income. If the same surgeon is now in his mid 60s and approaching the end of the career, the lender should cut back the loan amount substantially.
In a non-recourse partnership, a lender should look at the future growth of the underlying asset. For example, in a highly stable area with restricted supply, a lender may provide a higher LTV versus a declining area such as Detroit. Whether the borrower is a surgeon or a dishwasher is less relevant.
While logical, the aforementioned methods are illegal under current laws. If a lender refuses to lend to the older surgeon, that would be regarded as age discrimination. If a lender refuses to lend in the dilapidated areas of Detroit, that would be red-lining.
In the history of real estate financing, recourse and non-recourse have never been properly tested. The sub-prime fiasco was the first serious test and the system failed miserably. There are too many gray areas. For fear of political repercussions, many lenders have chosen not to exercise their recourse rights or are prevented from foreclosing regardless of their contractual rights.
It makes no sense to have one nation and two totally different financing systems. It makes even less sense to force odd shape pegs into one round hole, as the CFPB is trying to do now with all its meaningless regulations. If we are going to continue down the path of having both recourse and non-recourse mortgage loans, then it is imperative that they be separated at birth because they are completely different animals. They should have different underwriting guidelines, most likely different pricing and be sold in the secondary market as different products.
Finally, law makers and policy makers must respect the law. They must stop interfering with the right to exercise the terms of a contract, be it recourse or non-recourse. Until this issue is finalized, all other reforms are prematurely putting the cart before the horse.
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