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National Mortgage Professional
Sep 03, 2008

Hard money lending: Opportunities and risksPatrick W. Begoshard money, equity, liquidity, equity stripping It should come as no surprise to anyone involved in the lending industryprobably not to anyone outside the lending industry eitherthat lenders are under heightened scrutiny these days. The explosion of no-verification, sub-prime loans to borrowers who never had business borrowing money in the first place has served to make many view lenders as the bad guys. There is little question that lenders will be under pressure to ensure that any loan they make in the future is a proper one. On the surface, this would seem to rule out hard-money lending. By definition, anyone in the market for a hard-money loan is in some sort of financial difficulty. He may be in default on an existing loan. Certainly, if a borrower had a sufficiently high credit rating and capacity to qualify for a standard (even sub-prime) mortgage, he would not be shopping at the much more expensive hard-money store. Because borrowers looking for hard-money loans have problems with the first two "C's" (credit and capacity), it's a given that hard-money lending relies heavily on the third "C" (collateral). The problem with this is that the Federal Deposit Insurance Corporation (FDIC), along with the Federal Reserve, Office of the Comptroller of the Currency and Office of Thrift Supervision, has long been on record as saying that a loan made based on the assets of the borrower, rather than on the borrower's ability to repay, may be predatory. Many states are passing statutes outlawing, or otherwise penalizing, loans they consider predatorywith the definition of "predatory" often varying from state to state. Moreover, courts have long refused to enforce any transaction that is considered to be unconscionable. A loan, or any transaction, is unconscionable if it is so one-sided that no reasonable person would enter into it. If a loan is unconscionable, it is unenforceable, meaning that the lender cannot recover the money it loaned. Think of it as a court-imposed penalty for taking advantage of a borrower. Some types of hard-money transactions are likely to be found unreasonable, because they reflect an ulterior plan by the lender. One is called equity stripping. This is when a lender makes a loan with the expectation that it will foreclose and the lender takes the equity in the property. A second, related transaction is a loan-to-own transaction, where the lender generally wants to take and keep the asset itself, rather than the equity in it. The tips and advice in this article will assume that the lender does not have ulterior motives such as this. Because prospective hard-money borrowers are in financial difficulty and have little to offer other than the equity in their property, a typical hard-money loan is likely to come significantly closer than a standard loan to the blurry lines between predatory and fair, or unconscionable and reasonable. So, a hard-money lender has to walk a fine line between protecting itself sufficiently against the risk of default, and protecting itself so well that the loan is seen as predatory or unconscionable. I have seen this issue from all sides. I have represented lenders who were accused of making unconscionable loans. I have represented borrowers who I believed were the victims of unconscionable loans. And I have represented people who were seeking hard-money loans. From my perspective, hard-money lending has inherent risks and opportunities for lenders to overcome. But hard-money lending unquestionably provides substantial benefits to some borrowers, in some situations, while also returning a nice profit to the lender. The trick is for lenders to differentiate between potential loans that are good and bad. Though no short article can replace the consistent use of sound origination and underwriting procedures, I can provide several simple tips that will help lenders go a long way toward reducing their potential liabilities and ensuring that they are performing a valuable service. Don't make the hole deeper The first rule of holes is this: When you find yourself in one, stop digging. When you find a prospective borrower in a hole, don't go lending him a bigger shovel. Put another way: Just because you can make a loan, doesn't mean you should. A lender should always ask whether the loan will actually help the borrower solve an existing problem and leave him in a better position than the lender found him. Sometimes this is easy. Maybe the borrower has enough capacity to make the loan payments and is using your loan to keep his house while he rebuilds a bad credit rating. Once that is done, he fully expects to refinance to a conforming loan. A hard-money loan in that circumstance is beneficial to the borrower. But lets say the borrower doesn't have the capacity to make the payments on the loan she's applying for and tells you that she's going to use the loan proceeds to pay off credit card debts. The borrower is asking you to help her replace unsecured debt that she can't afford with secured debt that she can't afford. How is your loan helping her? It's important to remember that the lender should be convinced that the benefit from the loan is objectively reasonable. The fact that a borrower really believes a hard-money loan will be helpfulwhen objectively it is notdoes not protect the lender. Find the exit strategy This is closely related to the first point. What is the borrower's plan to make the required payments and to satisfy the note? You might find an exit strategy where the borrower has a temporary cash-flow problem, which you expect will turn around in the near futureassuming you have a reasonable, verifiable expectation of a change in cash flow. You might find an exit strategy where the borrower is looking for a true bridge loan until he can close on a sale of the property. And no, foreclosure is not an exit strategy. An exit strategy is the borrower satisfying the obligation without a default. I'm not suggesting that you should only make a loan where there is no possibility of default. But if all roads lead to default, there is a problem. Finding an exit strategy may not be easy. It's entirely possible that this is the farthest thing from the borrower's mind. A person who is drowning in debt may be focused only on keeping her head above water now; she'll worry about tomorrow, tomorrow. She may grab any rope that is near her, without checking to see whether theres a life preserver or an anchor at the other end. So you need to explore the exit strategy, and convince yourself that one exists. You are not required to weigh every possible post-loan scenario, but you must be able to say that, at the time of the lending decision, you had a reasonable expectation that the borrower would be able to satisfy the loan terms. This analysis will be much easier for the lender if the borrower already has a financial advisor assisting him in resolving his debt problems. No competent advisor will recommend that a troubled client take on more debt unless it materially helps his position. Make sure the loan matches the exit strategy Let's say you know that the borrower has serious, but temporary, cash flow problems. You agree that a loan will help him get to the other side of his problems. But your loan requires that the borrower immediately make monthly payments that you know the borrower cant afford. The borrower is going to default before he ever gets to the expected exit. If the problem is cash flow, you need to design a loan that fits within the borrower's resources. One option is to escrow enough of the proceeds to keep the loan current for a certain period of time. Another might be to have the loan negatively amortize for a year or two. Perhaps the loan provides for no monthly payments, but a balloon after several years. You should note that solutions like these work only when they are designed to meet the particular borrower's needs. For example, offering a negative amortization loan to a borrower who has no expectation of increased cash flow in the future will not help, it will merely dig a deeper hole. Don't over-promise One of my pet peeves when representing borrowers who are in need of hard money is loan terms that keep changing, usually for the worse. I especially don't like when it happens at the last minute. You may know the drill: The day before the closing, the Mortgage Broker calls to say that the interest rate on the loan is going to be significantly higher, that the cost will be five points instead of three, or a pre-payment penalty is being added. There may be legitimate reasons for such changes, but the changes may also be indicative of a bait-and-switch. A lender puts itself at risk if it encourages a prospective borrower (who is in financial distress) to spend weeks pursing an affordable hard-money loan (to the exclusion of other loans) only to change the terms materially on the eve of closing. Placing a borrower between a rock and a hard place in that manner can be an element of a claim that the loan is unconscionable. This is especially true if the lender, or the broker, had reason to know that the original quoted cost was unrealistic. No one expects a broker or loan officer to be able to predict, with certainty, what the loan underwriters will require. But its not unreasonable to expect the broker or loan officer to explain at the outset how costs may change and to disclose a range of potential loan terms. Make sure the borrower understands the loan One of the hallmarks of an unconscionable loan is that the borrower does not understand the terms of the loan. This can occur when the borrower has a language problem, or is not given an opportunity to read and understand the loan documents. This is an area where the law is somewhat contradictory, because it is well established that a person signing a document has the obligation to read it and understand it, or to get someone to explain it to him. But if a lender presents a two-inch high stack of loan documents to a borrower and tells him that he needs to sign them in the next five minutes or the loan is off the table, the lender may be asking for trouble. Of course, that's an extreme example. Not so extreme is when the borrower asks the broker or lender whether she needs a lawyer. It might be tempting to tell the borrower that she doesn't, because the lender's lawyer "will make sure everything is OK." After all, a borrower's lawyer is likely to make the loan process more difficult and time consuming for the lender. But a lender needs to resist the temptation to tell the borrower that she doesnt need a lawyer. In fact, the lender should encourage her to hire one. Though it might cost you some time at the beginning, it will help to insulate you from later complaints that you foisted a predatory loan on an unsuspecting borrower. Final thoughts Hard-money lending has never been for the faint of heart. At the best of times, it is a risky enterprise that requires the lender to exercise great care to protect itself against loss. Hard-money lenders don't need to close up shop in today's environment, but they do need to make sure that they are helping borrowers. It is not enough for lenders to protect themselves against the downside risk of defaults. Instead, they must work to minimize the likelihood of defaults in the first place. By doing so, hard-money lenders will offer more value to their borrowers, while giving themselves more protection from claims by those borrowers. Patrick W. Begos is a founding partner of the Westport, Conn. law firm of Begos Horgan & Brown LLP. He may be reached at (914) 961-4441 or e-mail info@begoshorgan.com.
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