Great recessions - the S&L Crisis, the Dot-Com Meltdown, and the Great Financial Crisis of 2008 - have not been kind to hard money funds.
Almost every hard money fund in existence before the S&L Crisis failed. The same thing happened during the Dot-Com Meltdown. Ditto during the Great Financial Crisis.
Are you currently invested in a hard money mortgage fund? Hmmm. Ted Turner, after he had just sold Turner Broadcasting to Time Warner, told his two sons, both executives at Turner, "You're toast." Cruel bastard. Haha!
The cycle goes as follows: A hard money mortgage fund is formed when a sponsor syndicates a bunch of private investors into a blind pool. It's like a mutual fund of trust deed investments, right? The investors' risk is diversified, and the pool is professionally managed. Secured by real estate. What could go wrong?
Then, almost predictably every 8 to 12 years, a stock market crash or a real estate crash (usually both) washes through. Real estate falls by almost exactly 45%. Investors then flood the offices of the sponsor demanding to withdraw from the fund.
The sponsor releases the tiny amount of liquidity on hand, but now he's stuck. He has no cash on hand with which to make new loans. He normally earns three points every time he closes a new loan, and he uses that income to pay salaries and overhead. His loan servicing income is absurdly low. This last issue is the fatal mistake.
Within three months of any crash, many hard money funds start to crash. Within nine months, unless the sponsor's family is as rich as George Soros, even the strongest of fund sponsors has thrown in the towel. The fund sponsor closes its doors.
The problem for the investors is that when the sponsor goes bankrupt, no one is left to watch the shop. When borrowers are late, no one calls to nag them. Many borrowers therefore stop paying altogether.
The real estate taxes on many loans go unpaid. Hopefully none of the properties burns to the ground after the borrower had stopped paying his fire insurance premiums.
Finally, the bankruptcy court appoints a trustee (cha-ching) to marshal the assets of the fund and a bankruptcy attorney (cha-ching) to represent the rights of the investors. The first thing the Trustee does is to appoint a CPA firm (cha-ching) to audit the books and conduct an accounting (cha-ching) of every loan in the fund’s portfolio.
In the meantime, no one is winterizing the buildings that have come back in foreclosure. Pipes are breaking, and the insurance doesn’t cover the losses (cha-ching) because the buildings were not kept heated. Vandals are breaking into the properties and are stealing the appliances and copper pipes (cha-ching) because no one has installed fencing and/or security alarms monitored by an alarm company.
OMGoodness. Hahahaha!
The Court then appoints a Receiver (cha-ching) to protect the assets of the fund. The bleeding slows from a gusher to just a steady bleed of gallons. The Receiver hires a property management company (cha-ching) to manage the foreclosed properties
But the Receiver only has so much give-a-darn, so he is not going to renovate any foreclosed properties before he sells them (dumb!), choosing instead to sell the REO’s (foreclosed properties) as-is at fire sale prices. Cha-ching, cha-ching.
The fund’s assets are relentlessly whittled down. By the end, the investors feel blessed to walk away with 30% to 45% of their original investment.
B&S proudly charges the highest loan servicing fee
in the industry. It's how we survive crashes.
Two years after the crash, new sponsors are starting up new trust deed funds. Seven to ten years later, the next crash hits. The cycle repeats itself. Again and again. Thank heavens its only been two years since the Crash of 2008. [Chuckle]
"But wait. George, your hard money shop, Blackburne & Sons, has survived for 44 years. How do you do it?"
Blackburne & Sons fractionalizes every loan. John Smith might take $30,000 in a $400,000 first trust deed on a San Jose mini-storage property. Mary Jones might take $25,000. A rich physician might take $50,000.
Title to these trust deed investments is then vested directly in the names of the investors (as opposed to some fund). "Stephen and Mary Calhoun, husband and wife, as to any undivided 11.34% interest."
If a North Korean missile ever takes out Sacramento and Blackburne & Sons (yikes, no longer a silly example), the investors would simply hire a local real estate broker to service their loan.
I genuinely believe that owning lots of small pieces in lots of different first trust deeds is a pretty decent way to weather the next real estate crash. The key is to own these investments in your own name, as opposed to that of some fund. Invest in fractionalized first trust deeds.
Disclosure:
Investing in first trust deeds involves substantial risk. A severe and prolonged decline in real estate values is possible. Be sure to study the Risk Factors section of the Offering Circular or Private Placement Memorandum carefully before investing. This is not an offer to sell securities. Such an offer will only be made when accompanied by an Offering Circular or Private Placement Memorandum.
And whatever you do, stay the heck away from any hard money mortgage funds! I am tempted to bet you a lobster dinner that the hard money fund in which you are currently invested was started after the Crash of 2008. Am I right?
Old Blackburne & Sons has been in business for 44 years. Please listen to this Eagle Scout and proud father to two more Eagle Scouts. :-) A poop storm is coming. Are you old enough to remember when the word, limited partnership, was reviled? Just wait.
I told you we try to have fun. :-)
