Affordable Housing Institute : US

“Our friend the Worldly Philosopher appears to have underestimated his vulnerability to appearances and the triumph of mob psychology,” said Holmes dejectedly, laying aside the Positions Wanted section of the Times.  “That is a pity, for it obscures the greater question facing his charitable society, and that is what lending they should pursue.”
 

“What type?” asked Watson, with the sickening sensation that he was letting himself in for another disquisition.  “Do you mean what form of money, hard debt or soft debt?  Or its place in the capital stack or the financing quilt?”
 

Holmes realized he would have to do some explaining
 

Holmes smiled with the self-satisfaction of the blogger’s pet.  “All of those are valid distinctions, it is true enough, yet I am thinking of something different — the type of borrower.”  He held up his hand to forestall Watson’s next prompting question.  “By that I do not mean the borrower’s creditworthiness per se; rather, why does the lender have confidence it will be repaid?  What is the main form of collateral?” 
 

As there are four types of capital, Holmes began, there are also four fundamental forms of borrower-lender collateral relationships.
 

Just as there are four of us, borrower entities are of four types
 

1.         Consumer finance.  “The simplest and most direct form: I lend you money, based solely on my confidence that you will find the means to repay me.  What bases do I use to assess whether you can repay me?”
 

Watson thought.  “My banking history.  My personal credit rating.  My position, my prospects.”
 

“Precisely so.  All of these, you note, are issues of your credit as a consumer.  They have nothing to do with the value of what you buy with the loan, indeed they are utterly indifferent to how you use the money.  I am financing the consumer, nothing more.  Examples include credit card loans, which are utterly divorced from the goods they are used to purchase, college loans, and personal loans.  How they do I assure you will pay me back?”
 

“You must be close to me, and able to motivate me to prioritize paying your loan over other obligations.”
 

Holmes didn’t appreciate that Watson was sitting so close
 

“Hence,” Holmes added, “most consumer finance loans are small, usually made by a local lender, and often carrying very high rates of interest on default.  In its purest, most distilled essence, this is loan sharking.”
 

“Loan sharking!”
 

I need you need an image makeover
 

“A pejorative name but really, it is no worse than any other form of lending in the money store; it fills a niche in the financial ecosystem because the high rates compensate the lender for the small principal amount and higher than normal repayment risk.  The problem, as demonstrated by the loan shark, is that a borrower who lacks financial resources must be incentivized to take extraordinary steps to find capital.  Ruinous exposure, the technique of that fellow Milverton, or the threat of broken kneecaps, both represent personal security not commonly used by more regulated lenders.”
 

“I’ll break every collateral in your body.”
 

“A less violent but nearly as economically pernicious approach is payday lending, where the lender interposes itself into the borrower’s payment chain, securing (de jure or de facto) a garnishee claim on future wages.”
 

“Lending to Wiggins, leader of the Banker Street Irregulars, is consumer finance.”
 

“The more benign form of the same financial approach is employer-assisted lending, where my security is that through your future efforts, you can work off your debt (literally).”
 

“You have shifted the ground somewhat,” said Watson.  “A pledge of future earnings, if secured with any kind of legal instrument, is a form of collateral, not purely consumer finance.”
 

Bud: Credit is a sacred trust, it’s what our free society is founded on. Do you think they give a damn about their bills in Russia? I said, do you think they give a damn about their bills in Russia?

“Quite right, Watson, the forms can intrude upon each other.  So let us consider the second type of lending, project finance.”
 

2.         Project finance.  “The form most common in housing — I make a loan secured not just by your personal promise to pay, but also by a piece of tangible collateral — a car, a boat, or your home, like that owned by the Norwood Builder.  In a project-finance loan, I have two sources of repayment: your pledge” –
 

“Surely,” interrupted Watson, “a gentleman’s word is his bond.”
 

“Yes,” Holmes answered imperturbably, “but commercial lending is predicated on doing business with people who are not gentlemen.  Aside from the borrower’s word, the lender also has a piece of collateral — a project, a scheme — which is the lender’s principal source of repayment comfort.”
 

“Lending to people less than trustworthy,” said Watson in a horrified wonder.  “It sounds so … mercantile.”
 

Watson was unwilling to lend to people he did not trust; Holmes had a freer approach
 

“It is.  As a lender, I am particularly interested not so much in who you are — although I conduct some due diligence — but rather in what you do with the money.  I take steps to assure you use it for what you said.  In an acquisition loan, therefore, the lender participates in the property closing, and places a mortgage lien on the property before the funds are released.  This is why home loan closings have an escrow agent — someone to whom the funds and title deeds are entrusted and who is thus treated as accomplishing a set of sequential tasks simultaneously, allowing all parties to feel their interests are being protected.”
 

From the lender’s perspective, Holmes went on, four elements make collateral desirable:
 

·         Tangible.  Physical objects — a yacht, an automobile, a television set — are much more readily assessed as collateral than intangible assets such as software, a copyright, a film script, or a brand identify.

·         Durable.  When the borrower acquires the collateral, the borrower typically uses it.  If the collateral suffers during its use (e.g. a television set), the lender must worry that the collateral’s value will depreciate, either through obsolescence or damage.  Durable collateral is safer and commands a higher loan-to-value ratio.

·         Recoverable intact.  Collateral must be repossessed — physically regained — even as it is legally cleared.  In some markets (e.g. some South African formerly black townships), regaining vacant possession (as it is known in law) may be problematic, or it may be difficult to clear senior liens (e.g. unpaid utility bills or real estate taxes)
 

“I will not harm the motor vehicle or the personal contents thereof.
Nor, through inaction, allow that motor vehicle, or the personal contents thereof, to come to harm.
That’s the repo code, kid.  Etch it in your brain.  Not many people got a code to live by.”

·         Remarketable.  Once the collateral is regained and in vacant possession, the lender (who now holds it as real estate owned, REO) must in turn resell it.  That means there should be a market for the assets, with reasonably liquidity and a wide enough universe of buyers to make the property’s resale easily practical.  Thus lenders love properties in strong real estate markets; when a market accumulates substantial unsold inventory, as may be piling up in the subprime sector, the lenders may have recovered the collateral but they take a loss on its eventual resale.
 

Before making a project finance loan, it is always important to inspect the property 
 

Watson studied the whiteboard list.  “With good collateral, I can see that project finance is definitely safer for lenders than consumer finance.  I suppose that is why home finance is so much cheaper than consumer lending.”
 

“Yes, and it is further why moving people into homeownership is an important step for their credit development, for the home-equity loan becomes the most readily accessible, cheapest form of financing average individuals will ever attain.”
 

“Having developed project finance, why would lenders ever go back?”
 

Holmes smiled thinly.  “When lenders go down the bankability pyramid, they tend progressively to distrust the collateral.  It is a projection thing — if a lender cannot imagine himself living in a home, he has difficulty imagining that home is good collateral.  So in nations undergoing rapid banking consolidation — South Africa after the end of apartheid” –
 

Watson was confused, for apartheid was not enacted legally until far in his future — 1948, and repealed in 1994.
 

– “After the end of apartheid,” Holmes continued, with an upward glare at the blogger’s editor, “South Africa experienced a substantial financial sector consolidation even as it was seeking to make loans into formerly black townships.  The acquisition of building societies by South Africa’s big four banks led to an institutional loss of memory, where project finance for homes was replaced by a consumer-lending or payroll-lending mentality.  In some future date such as 2007″ — again he glared out of the monitor — “South Africa will start painfully to relearn project finance home lending in the low and moderate income sector.”
 

“Yet, if my counting serves me,” Watson said, “there are two other forms of lending beyond consumer finance and project finance.  What could they possibly be?”
 

“That’s for me to know and you to discover tomorrow.”
 

[Continued tomorrow in Part 2.]

Send post as PDF to