Credit Market Crisis Counsel

This commentary from CNN Money was too good not to post. It is a little long but well worth the read:

"Stupid" investors, rejoice!
Ben Stein Economist, writer, lawyer, and actor

No one is too stupid to make money in the stock market. But there are many who are too smart to make money.

To make money, at least in the postwar world, all you have to do is buy the broad indexes domestically--both in the emerging world and in the developed world--and, to throw in a little certainty about your old age, maybe buy some annuities.

To lose money, pretend you're really, really clever, and that by reading financial journalism and watching CNBC, you can outguess the market day by day. Along with that, you must have absolutely no sense of proportion about money and the world at large.

For example, right now we are stewing over what everyone calls "the subprime mess" and going crazy, mourning all day and into the night--falling over ourselves to get all of the misery right, to paraphrase Evita. I'm writing this on Aug. 13, 2007, and in the past four or five weeks, the markets of the U.S. have lost some 7% of their value, or about $1 trillion.

But read on: The subprime mortgage world is about 15% of all mortgages, or $1.5 trillion worth, very roughly. About 10%--approximately $150 billion--is in arrears. Of that, something like half is in default and will likely be seized in foreclosure and sold. That comes to about $75 billion. Roughly half to two-thirds of that will be realized on liquidation, leaving a loss of maybe $37 billion. Not chump change by any means--but one-thirtieth, more or less, of what has been knocked off the stock market.

The "smart" investor nevertheless reads the papers, bails out, heads for the hills, and stocks up on canned foods. He gets a really big charge out of reading in the press that there are also problems in the mergers and acquisitions market and that some deals will not go through because there are problems raising the funds for the deal. He does not see that the total value of the U.S. major stock markets (the Wilshire 5000) is roughly $18 trillion. The value of the deals that have failed in the private equity world is in the tens of billions or less. The loss to investors--what the merger price was compared with the normalized premerger price--is in the billions. It's real money, and I could buy my wife some nice jewelry with it, but it's pennies in the national or global systems.

The "smart" investor also reads that the Fed has injected, say, $100 billion into the banking system in the last week or ten days, and says, "Aha! The whole country is vaporizing. Look how desperate the system is for money!" What he does not see is that the Fed is always either adding or subtracting liquidity and that recent moves are tiny in the context of a nation with a money supply in the range of $12 trillion. No, the "smart" investor is far too busy looking for reasons to run for cover and thinks he can outsmart long-term trends.

The stupid investor knows only a few basic facts: The economy has not had one real depression since 1941, a span of an amazing 66 years. In the roughly 60 rolling-ten-year periods since the end of World War II, the S&P 500's total return has exceeded the return on "risk-free" Treasury long-term bonds in all but four ten-year periods--the ones ending in 1974, 1977, 1978, and 2002. The first three of these were times of seriously flawed monetary policy that allowed stagflation, and the last one was on the heels of the tech crash and the worst peacetime terrorist attack in the history of the Western world.

The inert, lazy, couch potato investor (to use a phrase from my guru, Phil DeMuth, investment manager and friend par excellence) knows that despite wars, inflation, recession, gasoline shortages, housing crashes in various parts of the nation, riots in the streets, and wage-price controls, the S&P 500, with dividends reinvested, has yielded an average ten-year return of 243%, vs. 86% for the highest-grade bonds. That sounds pretty good to him.

The "smart" investor, in a bunker in the Montana wilderness, keeps his money in gold bullion. After all, he's heard that home prices are falling slightly nationwide and a lot in some areas (he ignores areas of rising prices like San Francisco and New York City). He says that this will discourage the consumer and lead to a severe, bottomless recession. He even has bald people on TV telling him he's right to worry.

The stupid investor, the guy who just lies on his couch, knows that the consumer is always about to stop buying and never quite does. Maybe someone in his bowling club has told him there has only been one year since 1959 when consumer spending fell--and that was barely, in 1980. Somehow, if the consumer could keep spending after the bursting of the tech bubble wiped out $7 trillion or so of wealth, maybe the consumer can keep spending even if the subprime "mess" wipes out roughly half of 1% of that tech-bubble loss and the stock market has a fit. And maybe he knows that, even if there is a recession, recessions rarely last more than two quarters, and the economy and the stock market revive mightily after that--and that buying stocks in a recession is a good idea, not a bad idea.

Now, the alert reader may at this point be saying, "Hey, that `stupid' guy who's really smart is a long-term investor. That's why he's doing so well." Correctamundo, alert reader. There used to be a saying: "Bulls make money and bears make money, but hogs get slaughtered." I am not sure that was ever true, but it sure ain't now. The real story is that long-term investors who have some sense of proportion make money. Short-term investors who live and die by the sweep-second hand of the $300,000 watch get rich fast and poor fast and sometimes are slaughtered faster. I have no advice for them except that the next train may be bringing in someone a little younger who's a little faster on the draw and a lot hungrier, so they'd better enjoy their Gulfstream while they have it.

For the rest of us, the stock market is cheap on a price-earnings basis, profits are fabulous, Mrs. Clinton and Mr. Giuliani are far from being socialists and in the long run, both here and abroad, stocks are a lovely place to be. I have no idea what the S&P will be ten days from now, but I am confident it will be a lot higher ten years from now, and for most Americans, that's what we need to think about. The subprime and private equity and hedge fund dogs may bark, but the stock market caravan moves on.

Find this article at:

http://money.cnn.com/galleries/2007/fortune/0708/gallery.crisiscounsel.fortune/13.html

How to calculate the maximum loan amount a property can support

The Google robots had us down for a day or two but we are back up and running. I guess we had so many people check out the updates on Monday that it triggered their SPAM alert. Alas...they discovered I was a Human Being (their wording) and unlocked the Blog.

Anyways, I am often approached by brokers wanting to know how high their investors can push their loan amounts. The LTV of the particular program does influence the answer to this question, but not nearly as much as the NOI of the property.

SO WHAT IS MY MAXIMUM LOAN AMOUNT?

The maximum LTV most income property lenders will lend to is 80%. However, the DSCR may reduce the LTV which the property qualifies for. This discussion will describe how income property lenders arrive at the maximum amount they will lend. This is probably the most important topic in income property finance.

The key to determining the maximum loan a borrower can get is DSCR. You will remember that DSCR is defined as NOI divided by total debt service.

Also remember that total debt service includes the P&I payments on all the mortgages that will remain on the property after your new loan is arranged.

Before proceeding let us review a little basic algebra. You will recall that if we have an equality; i.e. an algebraic expression separated by an equal sign, we can multiply or divide one side of the equation by anything we want, as long as we perform the identical operation to the other side of the equal sign.

For example, let us start with the following equation:
___ 6 = 2
___ 3
If we multiply both sides by 3, the equality holds:
___ 6 = 2 x 3

Armed with this brief refresher, let’s go back and use the debt service coverage ratio (DSCR) to determine the maximum loan our borrower can qualify for. Let’s suppose that we need a 1.25 DSCR for a very attractive apartment loan. If we use the same operating statement that we used in our discussion on the DSCR in my earlier post, we will see that we have a NOI of $55,000 per year available.

Substituting the numbers we have into the DSCR equation we find:

DSCR = NOI → 1.25 = $55,000 → Debt Service = $55,000 = $44,000
___Debt service___Debt Service_______________1.25

Now you can simply work backwards to determine the maximum loan amount the property will qualify for. Let’s assume the apartment loan being quoted was at 7% with a 30 year amortization. Now using your financial calculator use 360 for N, 7% for the % rate, -$3,667 ($44,000 divided by 12) for PMT, and then solve for PV. This should give you a maximum loan amount for this property of $551,127.

Knowing how the ratios work, you should be able to see that there are two ways that the loan amount can be increased. The first is to find the programs with the lowest DSCR requirements. This can be tricky because some programs that offer a low 1.15 DSCR requirement may come up with the same maximum loan amount if they have higher default expenses that need to be utilized.

The second thing that can be done to increase loan amounts is to find ways to increase the properties NOI. This may be done through more straight forward changes such as increasing rents or decreasing the vacancy rate in the property. More complex ways to increase the NOI would involve lowering expenses. The utility expenses are always a good place to start, but property tax and insurance expenses can also be a source of saved revenue if they can be lowered.

Please let me know if you have questions about ways to maximize the loan amounts of the properties you work with.

Commercial Crunch

Unless you have been on vacation in the Bahamas for the past 6 months, you should be aware of the serious credit market concerns in the residential mortgage market.

In fact, check out these new "Guidelines" I received from a Residential Lender today:

• All borrowers must have one Blue eye and one Brown eye
• LTV > 65% on SIVA asset programs require minimum credit scores of 849
• For all LTV's > 65%, 360 months of reserves are now required
• Borrowers must have no previous bankruptcies in their family history going back three generations
• A minimum of 25 years self-employment history is now required for all NIV Programs (at same location)
• Minimum credit scores for Subprime loans is raised to 720
• All non-arm's length transaction borrowers (mortgage, real estate professionals, family members) will be required to provide full-documentation, subject to criminal background checks, wire tapping, strip searches, and a minimum of 12 hours of interrogation by the Department of Homeland Security

Now that we have all had a good laugh, let's hope it really never comes down to this!

Anyways, during the first quarter of the year it looked like the credit market concerns would be limited to the Residential market, but that is no longer the case. With the relative strength of commercial paper being called into question, the PAR spreads we've known over the past several years have all been increased dramatically and higher LTV deals are also being cracked down on.

So why the tightening of the guidelines? In a very simplistic explanation, lenders are taking these actions to ensure that they can find a "buyer" when it comes time to securitize their notes. These deals are being affected because of the growing concern about the liquidity in the market to support such large transactions (securitizations can top $1B with ease).

So what is being done about it?
The past couple of months have had investors taking the classic "flight-to-quality" move into bonds. This has caused Bond yields to drop considerably over the past few months, though continued market volatility is expected for the coming weeks.

Though the Federal Funds rate is typically how the Fed influences market stability they took another course of action today. They first announced that $19B would be pumped into the banking system in an attempt to alleviate the growing concerns about liquidity, and then increased it to $35B and finally $38B. This mirrors the actions of the European Central Bank pumping $213B of liquidity into their banking system over the past two days.

From a financial point of view the $38 Billion infused by the Fed is a small ripple in the wake of the US economy. However, we live with an emotional market as much as we do a financial one and so the infusion is bound to settle some concerns about the markets liquidity and stability.

So how can you be successful in such a turbulent time?
Commercial Mortgage Backed Securities (CMBS) deals have traditionally had rates which were much lower than portfolio style programs. The credit crunch we are in the middle of has changed the playing field, and as a result that difference in rates is not always the case anymore.

For example, we recently received a quote back from a top CMBS source and for that deal it was 15 bps higher than what we could offer on one of our own portfolio style programs. We are able to close the deal either way, but it sure was great to be able to offer a program with a rate lower than what the other conduits were offering. Throw in the lower application fees, less restrictive prepayment penalties, and greater program flexibility and it was a great deal for the borrower.

What this means for you is that it is now easier to win over some of those $2-$5M deals with faster, less expensive, portfolio style programs. The key is to find programs that you know offer a competitive advantage to what the market is offering, and then go out and find the properties which fit those programs.