Beware the unofficial agent - Posted by Bob Smith

Posted by Bob Smith on May 26, 2006 at 03:14:16:

I see how an insurance company can raise good (huge?) sums of money by selling annuities, especially by selling single-premium annuities (deferred annuities are best, because of the float). Nice, big chunks of cash in one shot, rather than wasting your life waiting for capital at $100/month on an installment annuity. Tough for a new, small, unrated insurer to get business, though. Other than that, how is an insurance company, specifically, a good vehicle to raise money?

Are tax benefits an issue here? I can’t find a good reference, but I’ve heard that an insurance company can earn some of its investment income tax-deferred if it’s for building reserves. The thing is you can’t be just a shell; if you’re really just an investment company and don’t sell any insurance products the IRS will be very unhappy. If you instead pay some of that out as dividends the company will of course owe tax then. Warren Buffet’s insurance companies supposedly have billions of dollars in deferred tax obligations on their books.

It’s not clear to me how the pool can be used to buy partials. Are you giving the seller an unsecured promissory note for the tail backed by the assets of the pool?

I see how the pool could be used to back bonds, just like CMBS, if the pool is large enough to make the cost of an offering worth it. Are you talking about actually issuing pool-backed bonds rather than the usual one investor per note? I don’t see how an insurance company “insures” the pool any better than anybody else with a comparable set of notes can.

Documenting the pool’s paper improves your ability to sell and quickly capture most of your discount, but I don’t see how that improves your ability to find more paper and solve the “too much money, not enough discounted notes” problem. Speaking of which, when does it become a problem? Metropolitan Mortgage had hundreds of millions of dollars before they went bankrupt, which is, I suppose, the kind of problem most of us would like to have.

As I recall CMOs have two problems: they usually pay a premium for their paper, so early payoff results in a loss, and there’s no point in getting $150k in non-performing capital (whether from early payoff or foreclosure) working again when you’re managing a billion-dollar pool of mortgages (assuming the manager knew how to make it performing, which is unlikely).

Beware the unofficial agent - Posted by Bob Smith

Posted by Bob Smith on May 17, 2006 at 15:11:03:

http://lawprofessors.typepad.com/unincorporated_business/2006/05/texas_case_on_u.html

Trust is a dangerous act - Posted by John Behle

Posted by John Behle on May 23, 2006 at 14:28:17:

That illustrates some dangerous and foolish business practices. FNAC and other national lenders have made some very costly mistakes the last few years.

It might help to illustrate just how dangerous it can be to buy notes nationwide or in an area outside of your own. I have avoided it for 30 years myself and taught my students to do likewise. When experienced and well trained buyers take large hits, imagine how bad a smaller company or an individual can be damaged.

“In their defence” might be the next sentence in a reponse like this, but not from me. The Lender’s actions were foolish and they set themselves up to be burned by the broker. From my quick read of the facts, they gave the broker money and he kept it instead of funding the note. They trusted him to do the closing.

Every time nationwide paper buyers start trusting their “brokers” they open themselves up to fraud, incompetence and losses. This same lender took a giant hit a few years back from over-extending credit to an easily recognizable flake. As the statement goes “first a peac-ock then a feather duster”. They bought into a broker’s hype, bravado and circus antics and lent too much to an in-experienced egotistical young punk. (sorry for the colorful terms, I never liked him - and I learned long ago to see through promoters.)

So, first problem.

1 - Out of state lenders have to trust someone. If they are smart, the person they rely on is an independent third party. An “in-house” closing with a broker is nuts. Third party professionals need to be used. Using a title company or closing attorney would have prevented the whole mess with this case you pointed out. In their previous losses with the young broker, they relied too much on documentation provided by the broker and he was reckless. When money is easy to get and a broker is making money on commissions, they can get very loose with their purchases or even resort to downright fraud (not saying that broker did).

2 - They try to cut costs. That is why they tend to want to find people to trust, so they can do the “due diligence” cheaper. That can be documents provided by the broker or work done by the broker or documents passed through them. Another case about ten or so years ago was another prima donna broker and a lender that prided themselves as being a “great” nationwide buyer and authority in the business. We’ll call the broker “Donna” and the Lender “Strauss”.

Donna brokers a note to Strauss. Strauss relies on documents provided by Donna. A title report/policy, closing documents, etc. Strauss seemed to be counting on Donna’s expertise or reputation as a mega broker. Donna took the documents at face value as provided by the note seller.

The trouble was, the documents were fraudulent. Letterhead and documents dummied up from a real title company, but not a real transaction. That’s an age old scam, that an inexperienced broker or lender does not need to fall for, but they do when they cut corners. Cutting costs usually means cutting corners. Trusting facts, figures or documentation given to you by the seller of a note is like asking a TV evangelist if he thinks you should send him money. No slam on evangelists, just an illustration of someone asking a loaded question that will receive only one answer and not one that is objective.

I guess I was “lucky” years ago to run into a little old gray haired lady who was a real estate broker. She seemed like everyone’s sweet grandma. Clara was trying to sell me a property. I was busy and said I would need an appraisal. She said “no problem” and came back the next day with an appraisal.

I know this little old grandma had cookies in her purse for the grandkids. She also had bottles of white out.

The appraisal she brought me was a photocopy. She had found an appraisal to match the value she needed and whited out the subject property and typed in the one she was trying to sell. I call this an “appraisal du Jour”.

So, I figured if a little old grandmother was going to try to perpetrate a fraud on me, that anyone would. I’ve also had numerous other appraisals brought to me where the appraiser was bribed, intimidated, duped or just plain incompetent. And I’ve had a ton of other documents brought to me that were phoney, altered, etc.

So, you don’t trust documents and information provided by someone trying to sell you something. It may provide information that helps you in your due diligence, but it should not be relied on solely. Even an appraiser hired by someone else should usually be thrown out, taken with a grain of salt or audited for accuracy.

In the case ten years ago, Strauss could have even made one phone call to the title company that would have revealed the documents provided were fruadulent. Instead, they trusted the broker, who trusted the seller who scammed them both. Then they sued the broker and of course the seller of the non-existant note was long gone.

Finger pointing after the fact did no good. The lender felt the broker should have done the due diligence (wrong) and the broker felt if was not their job or responsibility (wrong). To me they both messed up. Strauss took a loss and backed way away from their nationwide lending. The broker went on to develop an even bigger brokerage and crash that company with the same sloppy procedures and policies.

In my local market, I turn down notes, properties and deals all the time from people I know of by reputation. You can’t do that as easily if you are trying to cover a whole nation. I or an assistant check out deals carefully that can not be done on a national basis.

Here’s another example. My biggest local competitor about 20 years ago was a thrift and loan. We had a good relationship and did some deals together. I enjoyed going to lunch with one of them and we had an interesting conversation one time when he told me about a scam that had come their way.

Someone had gotten out of prison and jumped right into the scam they had hatched while there. They set out looking for properties with “Citibank” loans on them. They would buy the property and then turn around and sell it again for a low downpayment on a contract. They then sold the contract. Their claim was that they were a lender out of another state that had had to foreclose, so they were just doing a “quick sale” on the property. The title policy showed to the paper buyers that the note was in a first position and that the Citibank loan had been paid off. I think they particularly targeted institutional note buyers knowing they would just rely on title insurance. Don said to me - too bad they didn’t bring a deal to you John, you would have found their con much earlier. Don had a copy of my book and knew that I did a quick abstract of title on any note deals. An abstract would have shown their “story” about being a lender was bogus. Title insurance companies took a loss in the millions when a year later Citibank finally figured out that someone was fraudulently reconveying documents. I think the scammer even had the signature down of someone at Citibank that “could have or would have” signed the reconveyances. Once again, relying on documentation is dangerous.

There are also many cases where values have been erroneously inflated through fraud or speculation. It takes seconds to pulll some comps and not waste time or money on an appraisal. Much of the time when I go to pull comps, they property the note is on comes up for sale or shows several recent sales.

The type of due diligence I can do in a local market is much better, cheaper and easier than what someone can do on a national basis. It’s safer. I truly believe only the most experienced pros should consider investing outside their area and then as we’ve seen, even some of them get burned. The two national lenders I referenced have some higly trained and respected people involved. They aren’t amateurs - just pros who cut corners.

I don’t know all the details of Metropolitan who was the biggest nationwide buyer. They went down the tubes. From what I have been able to read in their local business journals, etc. it had much more to do with bad real estate deals that they did than with bad note deals. They couldn’t find enough paper to keep them happy nationwide so they started doing some very speculative real estate transactions in their local and surrounding markets. Nepotism was their true problem. The second it changed hands it was doomed.

Any time you begin to trust someone with your money, or the security and safety of your money, you are making a mistake. One of the greatest elements of note investing is that you do not “HAVE” to trust someone. You can verify documentation and valuation and the property will always pay you if the people don’t. When people stray from that it is dangerous.

I had a student that was going gangbusters. He was a shining star and doing profitable note deals. He began to think he could branch out and started buying car paper. That can be riskier, but still can have some good collateral. I don’t recommend it for the average note investor to consider. He did OK with the car paper he bought, but then a “dealer” wanted to do more. He expanded and did more deals with the dealer and trusted the documentation brought to him by the dealer. Now remember, this is a used car dealer we’re talking about. The dealer started providing phoney titles to non-existant cars and the student took a big hit and spent years digging out when the dealer took off. If you can’t go kick the collateral - and don’t do so, it isn’t investing, it’s speculation. If you don’t absolutely, positively KNOW the collateral is worth enough to be sold and pay you if need be, then it is a deal you should not do. You never loan to a person, you loan against collateral. I’d rather have a million dollars of collateral than a millionaire.

Sorry to ramble on, but your post brought up an important point about brokering notes nationwide and the potential risks.

Re: Trust is a dangerous act - Posted by Natalie-VA

Posted by Natalie-VA on May 24, 2006 at 11:50:01:

John,

Would you recommend that someone new to the note business actually use an attorney instead of a title company?

I have quite a bit of RE investing experience, and I’m very comfortable with values and having those transactions closed by a title company. I wanted to look more into the note business and wondered if I should retain an attorney. Someone who who actually reviews the documents and issues title insurance to ensure I’m protected. I know that some lawyers don’t even lay eyes on the file until they’re sitting at the closing table, so I would have to find the right one.

Thoughts?

–Natalie

Re: Trust is a dangerous act - Posted by Bob Smith

Posted by Bob Smith on May 23, 2006 at 17:06:02:

>Someone had gotten out of prison and jumped right
>into the scam they had hatched while there.

Cute scam. A sobering reason to always get title insurance, from a well-reserved insurer (I know some people who lost big when a SoCal branch of First American went bankrupt), when buying mortgages. Did the note buyers end up having to reimburse the title insurance companies? Speaking of mortgagee’s title insurance, do they pay off at your purchase price or at the note balance?

>I don’t know all the details of Metropolitan who was the biggest nationwide buyer.

As I understand it, Metro deviated from its core business (note buying) and got its head handed to it. I had heard Metro was funding its note buying business by selling annuities. Do you know how that worked? And just what is the 4th way to buy a partial?

>There are also many cases where values have been
>erroneously inflated through fraud or speculation. It
>takes seconds to pulll some comps and not waste time
>or money on an appraisal. Much of the time when I go
>to pull comps, they property the note is on comes up
>for sale or shows several recent sales.

What are the badges of fraud here? Please explain how one uses comps to detect fraud.

Re: Trust is a dangerous act - Posted by John Behle

Posted by John Behle on May 24, 2006 at 01:34:48:

On the first scam, the title insurance companies paid off and took a bath. The mortgage buyer didn’t lose at all. At that time, they were a thrift and loan and when we had our thrift and loan crisis, only two had the financial stability to become banks. This one and one other that both invested in paper heavily.

That’s the same I read about Metro too. They had dabbled in real estate for years, but jumped in big time when the management changed hands. That was the major cause of their problems.

They had an insurance company. Can’t think of the name at the moment, but they sold annuities to get money to buy notes. Sell notes to buy notes. I always thought it was a great plan. We were in the process of buying an insurance company some years ago, but the owner had health problems (I think it was Lou Gehrig’s Disease) that deteriorated so quickly that we couldn’t get the sale concluded while he was still able to.

Pulling comps can give me a real good idea of the value in seconds. People kind of mis-understand the complexities (or lack) of appraisals. It is very easy to come up with a range of value on a property within a few thousand. It is the art of narrowing it down to a precise figure where the true skills of an appraiser come into play. If I pull comps I can have a good idea of the value and it can help point out if an appraisal is out of line. I will also investigate the appraiser’s comps. Actually, I may end up pulling the same comps as him anyway. MLS data can tell me if the prices of the comps are real. I have seen where the appraiser was given comps by a builder for example that were highly inflated. Other times the appraiser’s comps are out of line. They may be too far away or poorly chosen for some reason. Most cities have situations like ours where a property will differ in value by 5-10% or more just by crossing the street. Or a property may be over built for example and worth one price in the area it is in and a much higher one if it were in the area of the comps. But - it’s not - and if the appraiser pulls those properties as compas without an adjustment for the area it is an error. It may just be as little as a block or two.

Pulling comps may give me a better value than the appraiser. For example, I had an appraisal brought to me where the appraiser had pulled two single family homes as comps for a multiple unit. You could argue that the properties were almost identical, but single family homes and a triplex - even a conversion - are apples and oranges.

As I mentioned, in pulling comps, the property that is collateral for the note may actually come up. Sometimes it becomes clear that there has been multiple sales to inflate the value. Other times it is clear that the value was puffed up by easy terms. Sometimes a situation like double contracting becomes clear. The MLS data might show one price where their documents they are showing me state another price.

The fourth way to do partials involves a risk pool. It would actually function best with an insurance company and annunities. Something Metro could have really capitalized on if they had a clue. Based on results they didn’t.

Re: Trust is a dangerous act - Posted by Bob Smith

Posted by Bob Smith on May 24, 2006 at 13:11:08:

Were you looking to buy an insurance company so you could copy Metro’s business model? The tax (premium and gross receipts) and regulatory burden of an insurance company didn’t turn you off, I take it. In your opinion, are those factors overblown, or well compensated for by other factors?

Re risk pool: if I understand it correctly, rather than guaranteeing payment of the tail out of the proceeds of the note being purchased, as the other partial purchase methods essentially do, you’re doing so out of the general assets of the company. Is that right? Where does the annuity fit in, then? Are you buying the note for cash plus a deferred annuity (the tail)?

Re: Trust is a dangerous act - Posted by John Behle

Posted by John Behle on May 25, 2006 at 01:56:44:

I’m not so sure I even was aware of Metro’s model at the time, and it wasn’t the reason for our interest. Besides annunities, etc. an insurance company can be a great vehicle for raising capital and we saw it as a good tool for creating a funding source to buy notes from our franchisees and/or loan money to them secured by notes. A functioning company would not have been feasible. Our focus was on a shell. A company that has gone through all the hoops and registration, but was not heavy into the business.

As to the risk pool, think “Lloyds of Loans” instead of Lloyds of London. Pooled risk. Instead of just focusing on those people that have notes and need cash, this was more geared towards partials or even just someone wanting better security.

One individual owner with a $50,000 note has potentially great individual risk in cases of default, etc. If that particular note goes into default, that note owner is all of a sudden out the income, needing money for an attorney and if they are not in a first position, they also may need to make payments on underlying loans, etc.

If ten people jointly owned ten notes, the individual risk is incredibly diminished. If a hundred people each have a 50k interest in a 5 million dollar pool of notes, the individual risk is gone. Plus, the notes are professionally managed. Collected properly, etc. Plus, once someone understands the upside profit potential of notes through restructuring, early payoffs, etc. the “Pool” could be very profitable. Basically it fills the role of private mortgage insurance for private mortgages - but through a cooperative. Now, another purpose of the insurance company was also to take the second step and actually insure the pool once it had grown and had a track record. All of a sudden, private carry back mortgages turn from a potential problem to a great investment alternative. It becomes a mortgage backed security instead of just an individual IOU. Beyond that it has the potential to become almost a mortgage backed currency.

Part of what had gotten me excited by an insurance company was the interest of Metropolitan. Not the little one in Washington - the giant multi billion dollar Met-Life. They were interested in investing some capital with us in mortgages.

Add another fun little element to it and look at the success and problems of “CMO’s” or Collateralized Mortgage Obligations. There is some major money in the stock market that invests in these. They can be a great investment, but I was reading one day about their greatest challenge and concern which they term “refunding”. Refunding is getting paid off early. Interest rate fluctuations lead to people refinancing and the CMO’s have the challenge of getting their money back and having to put it out at a lower rate. But, refunding when it comes to discounted mortgage investment is a windfall profit. Since your profit comes from the discount instead of the rate, getting the discount back quicker results in an astronomical yield. If the CMO’s had any sense they would balance their portfolio of conventional loans with discounted mortgages. One of the people at Met-Life “got it” and was interested in pursuing it.

The challenge with discounted paper is getting enough of it if you have major dollars to invest. It was a huge challenge for the Washington version of Metro and that challenge is part of what led them to “diversify and die.” The risk pool could perform professional loan servicing and document the paper to FNMA standards. That fits right in to what we have done as a service for real estate agents and others that are involved in seller financing. We have a “due-diligence” package that puts the right documentation and details into place right up front. One of the challenges with discounted mortgages is that you have to do the due diligence after the fact as a buyer. That is a large reason why discounted paper has a liquidity problem and is not as desirable to institutions. The note buyer has to do the due diligence after the fact when they buy it that should have been done before the loan was placed.

But, between the owner of the insurance company’s health problems and my heart attacks, that particular rocket never got launched.