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
[email protected].
