The Wall Street Journal reports on the niche, but growing, market for so-called “hard money” loans. Good reporting by Dawn Wotapka on an undercurrent in the credit markets. Hard money loans feature borrowers with credit problems that cause them to be shunned by banks; very high interest rates; short term; substantial if perhaps illiquid security; and “peer-to-peer,” non-institutional lending arranged by a loan broker:
Across the nation, a number of mom-and-pop investors are pulling money out of their retirement accounts and safe, but low-yielding, savings to take on the risk of becoming “hard-money” mortgage lenders, who charge high interest rates to borrowers who have been rejected by traditional banks.
Hard-money mortgage lending represents just a tiny slice of the mortgage market, although the activity is growing rapidly. Guy D. Cecala, publisher of trade publication Inside Mortgage Finance, estimates hard-money loans will account for about 1% of the 5.5 million mortgages expected to be originated this year. But he says activity in that sector is up sharply from a few years ago, when very few hard-money loans were originated.
On the lender side, there is a question as to whether the “mom-and-pop” lenders – ranging, in the article, from young professionals to elderly retirees, but all chasing yield in a drastic way – are adequately pricing their risks. Perhaps they are sufficiently overpricing the loans in a niche market that they are reasonably well covered across a relatively small run of loans, and perhaps the lack of diversification forces them to concentrate sufficiently hard on the borrower to compensate. Still, there’s a question, particularly if the peer-to-peer model spreads, via individual and small investor seminars and the Web, whether credit standards are maintained, or whether it goes from being a profitable but self-limiting niche market into something that looks more like subprime. Since lenders are dealing with borrowers with credit problems to start with, that’s automatically an issue even if, within that subset, there are borrowers with special issues that can’t be efficiently dealt with by financial institutions, but which individually tailored lending might address.
On the borrower side, there are also cautionary issues. One is the interest rate, of course. At 12-15% rates, the activity supported by the lending must be able to support a short loan term, whether that is repayment, over and done, or some form of rollover into conventional bank financing. This puts the borrower into the position of so much Wall Street financing in recent years; financing at very short terms, for economic activities requiring much longer horizons. The article suggests that default is rare, in large part because the lending is substantially collateralized by property for which the borrower would truly hate to lose the equity.
My cautious sense is that there is a niche market that can and should be filled, but that it is one that has special conditions for lenders and borrowers. The starting question, for both sides, is why the bank won’t make the loan and see whether the problem is the borrower or the transaction and monitoring costs to the bank as a lender. In many ways, this resembles developing country microfinance. The one-day loan to the open-air fruit seller carries an apparently astronomical interest rate, but it is not significant on an overnight basis. The problem, rather, is what happens if something goes wrong and the fruit is not sold and the loan can’t be repaid as it comes due:
Typically, hard-money lenders are matched with borrowers through loan brokers, who make a commission on each deal. Most loans are short-term, lasting a few months or as long as several years. Some are set up with low monthly payments and a balloon payment due at the end of the loan term.
When the loan comes due, borrowers either refinance into a conventional mortgage, flip the property to pay off the loan or, if those measure fail, extend the hard-money loan. “The hard-money loan is an interim loan,” says Sophie Lapointe, a co-owner of Five Star Mortgage in Las Vegas, which doesn’t do hard-money loans. Lenders say that defaults are low, in part because borrowers have plenty of equity tied up in the properties themselves.
Moreover, peer-to-peer lending is gaining traction in development contexts – Kiva, for example – via the internet, but with many unanswered regulatory and risk management questions, as my colleague Anna Gelpern and NYU’s Kevin Davis discuss in this article. One of the broader economic questions, relevant to both the development context and the growth of peer-to-peer lending in the US is whether it is a long-term and reasonably efficient way of filling a credit niche using new technologies such as the web to reduce the monitoring costs incurred by an individual lender.
On this niche-filling model, new technologies allow for direct monitoring by an individual lender of an individual loan in what amounts to a genuine innovation; the institutional lender would have to substitute indirect mechanisms for dealing with the risk, such as essentially unmonitored diversification of loan portfolios, which are less efficient because they average out risk, rather than addressing it head-on. Or whether, instead, these are loans that in a more normal credit environment would be filled institutionally. And which are creating risks for the “peer” lenders that are not being accurately addressed because the lenders are so focused on chasing yield.
Update: There are some very interesting comments below, from some folks who appear to know the business up-close. Recommended.