E320 | What Bank Balance Sheets Tell Us About the Future of Note Investing

Welcome back to the Paper Trail podcast where we follow the numbers, decode the headlines and translate data into opportunity for mortgage note investors.

And people are probably asking what the heck is bank call report data?

And most people don't know this, but the banks every quarter must report their information to the government and all this data gets collected and a bunch of people out there analyze all of this data to figure out what how banks are doing.

Are banks strong?

Is each you know what's going on with all the different banks?

And today we'll talk more about the macro conditions, not a specific bank.

And little spoiler alert.

Let me just tell you, banks are not bullish on the economy right now.

Lending is slowing, defaults in certain segments are starting to creep up and many large banks are loading up on trading assets, not loans.

And that has some real implications for people and note investors in the space.

So let's unpack what all this means without all the fancy jargon so you know where the proverbial puck is headed.

So let's first talk what the banks are doing.

Let's talk about what they're not doing.

Banks have really tightened lending and top line number bank assets jumped by about 436 billion in quarter one.

That sounds like a really big number, 436 billion.

But here's a catch.

Over 70% of that growth came from banks trading assets and security repurchase agreement.

You ever heard term repos?

That's what that is.

So actual loan growth was less than half a percent.

And even more telling in this was one to four family mortgage loan balances actually shrank.

I'm not sure you know how often that happens, but it's not very often.

I believe consumer portfolio loans like auto and credit cards were also down.

Most of the growth in the lending came from two categories, non depository financial institutions and purchase and hold security loans.

And that's really not the economy getting credit, It's Wall street really just moving money around is really what all of that means.

So think about it this way.

There's not a lot of inventory or new loans coming into the space.

Just everything that's there is still getting shifted.

Now let's be honest for us note investors, most of us being in a 15, 16, however many trillion dollar industry, you're just a speck in the universe and you'll be able to find loans.

But it still matters for note investors.

So what does this have to do for those of us who are in this space?

When banks slow lending to consumers and households, cracks eventually show up in consumer debt performance.

And here some of the takeaways I think people should take away from this episode.

Slower lending typically means higher default risk.

Later, less new lending can signal some caution.

As credit tightens, distressed borrowers often can't refinance or resolve delinquencies.

That means more defaults and more non performing loans and more inventory coming to the market.

But that's such an anomaly and I cannot tell you how many bigger pockets, Facebook, Reddit posts I see from people who are equity rich and cash poor and they might have 30, 40% equity in the property, nobody will touch them and they can't afford that property anymore.

Now what happens in those instances is they end up having to sell and then they sell at a discount.

Then all of a sudden somebody else nearby has to sell at a discount.

And what does that do to overall real estate comps?

Comps go down.

So it's going to impact.

You could be a great operator on a rental property or any other property or homeowner, but if everyone around you can't manage your finances, it can impact you.

So just be aware of that.

Clearly banks are shifting away from some of this direct exposure, these fast lending categories that are, I'll call it like the rocket mortgages who are non depository, meaning they don't take, they're not a bank, they're large companies.

I think UWM is another one.

Some of these securities and they're doing this because it's easier to move off their balance sheet.

For example, they get all these loans and they turn around, securitize them to Wall street, much easier.

Mortgage backed securities, you may hear.

But many of these underlying assets are loans that are in disguise.

And as these, especially the commercial side, you see these portfolios mature, you're going to see rising delinquencies, amateur defaults, which is opportunity for note buyers who can work out extensions, modifications to avoid even taking some of these back by foreclosure.

Now what also has caused some of this, let's be honest, underwriting quality kind of look shaky lately.

Some banks are reportedly even doing note on note financing at 90 or 100% of LTV, basically lending against other loans to offload risk.

That's short term optics, not long term stability.

I don't know any loans that are doing that.

I'd love to find some loans that are financing other loans but that's again kicking the can down the road and could lead to more distressed paper in the future.

Especially on some of these junior liens.

Now when people are doing that we start connecting the dots.

The actual note investing first lien mortgage balances shrank.

Let that sink in that for a growing economy people are buying refinancing.

With all the equity people have between refinancing and buying, balances actually shrank.

Think of how many mortgages are like 3%, so how much?

Yes, a good percentage of that is now principal versus interest.

But to me it's just mind blowing that you see that balance shrink.

To me it's almost like seeing population growth shrink.

It's hard to grasp.

Now junior liens and helocs of course saw some small upticks and that goes back to what I said earlier where you've got the equity rich cash poor people and they're trying to survive.

I know an investor, not going to name the name or the state who has a pretty large portfolio of assets and they were looking for some assistance financial basically an equity partner step in because they thought they were cash negative x amount of dollars every month.

When we looked at it they were about 5x negative cash equity in cash flow per month and where they needed to be.

Now they had significant equity in their portfolio but now it was about 40% equity.

But going to a lender is only going to give you on a HELOC today.

If you can get up to 70% loan to value, you're doing great.

Most of them are at 50, 60%.

We passed on that opportunity because we didn't see an exit.

The portfolio was an investment portfolio so it was all over the place for performance.

And knowing what we know, with delinquencies rising in residential, commercial, new construction and other consumer segments, the only exit was to sell.

And we didn't want to be part of having to kick in additional cash to own a portion of portfolio, give them a loan to then take these assets back.

Also again, some regional and smaller banks are showing distress that could lead to bank failures or portfolio liquidations.

A few years ago, the company Peer street as an example, was doing a lot of lending.

They failed, went under and that whole portfolio ended up getting liquidated.

So don't be surprised if over the next 6 12, 18 months we see more defaulted loans.

I'm seeing it already, but a Lot of what we're seeing is on the investor side of things.

We're starting to see some cracks in people buying homes during COVID but the rates are still very very low and the price points aren't making sense right now.

But where we did see a good uptick in defaults is also some of those junior liens that people had equity and maximize equity in their property and now again are back to racking up credit card debt and not able to pay.

As I mentioned, I keep reiterating this, it's going to probably lead to more product available, also better pricing as funds and banks look to exit.

There's more inventory, is there less people buy this paper.

And I recently mentioned on another podcast this increased foreclosure activity probably going to lead to more investors taking properties back.

So be careful, be prepared.

That might occur.

So how do you prepare as a note investor?

Great question.

So what do I recommend?

They mentioned in a prior podcast build your take back team.

Now if you're seeing more foreclosure activity, you need boots on the ground.

Realtors, preservation companies, contractors, property managers, the attorneys.

Start getting them lined up now because not only do you need them for the deals, they may actually lead you to some deals.

They may know somebody who's in trouble.

You might be able to buy that loan.

Second, choose your target and choose it wisely.

I know some who are targeting second liens, some in helocs, some who are targeting non owner occupied single family, some doing commercial.

Now the seconds and commercial of course are the first segments to show the cracks and also the most discounted notes you can buy.

But they're not for everybody.

So pick your target.

I also recommend that you stay cautious with reperforming loans.

With some of this consumer weakness data, even reperformers could slide again be extra thorough doing some of that property level in person due diligence.

What I thought was really interesting was it was actually comical I should say and I did not call this person out.

Which I really wanted to was I'm in a very large group with a lot of people who are passive investors and this person made a comment that they pulled out of every non performing note fund they invest in and went to a performing note fund specifically theirs or one they're affiliated with, work for whatever.

And I just if it was not the most, what's that term where you're self promoting post I've ever seen in this group which you're not supposed to self promote, I was like of course it's from this person which this person only sees rainbows and unicorns about their philosophy and their assets.

But to me I look at the exact opposite.

Non performing note funds are buying assets already non performing and at a discount performing loans you're paying a heavy premium for, especially reperforming.

And if they go non performing you will lose.

You know you're going to lose money on that deal or you're not going to make enough to pay your investors back point blank.

Tell you that right now.

I know some debt funds that only focus on performing and I can share with you their financials.

They are ugly because of their default rates.

So if someone tells you that in a downward economy at performing loans, again non performing or higher risk, of course they are.

But if you have two people are very good at managing each asset class, I wouldn't say get out of one and go to the other because the other one could also have some significant and serious issues.

Also, when you're on the lookout, be careful of the tapes you're looking at.

Some of them can also have really hairy assets.

Some of them, for example, a tape we saw had a lot of bad paper with lawsuits.

Others again people trying to get rid of exposure in regards to super low interest rates.

Make sure you target every exit strategy and don't just say oh this looks great on a foreclosure, but if they were able to reperform or file bankruptcy, it crushes you.

Be careful of that.

And as always as I wrap up episodes, if this feels overwhelming, consider investing in a fund working with experienced operators because they invest passively in a mortgage note fund like us at 70 as we actively adjust our strategies based on data like this and data that you don't have to spend a Sunday like I am scouring through to see where we're headed and start planning accordingly.

So my final thoughts in this episode as we wrap it up.

Clearly big banks are starting to pull back from some of that traditional lending.

They're more leaning harder into trading and off balance sheet strategies.

We're starting to see early signs of distress, especially emerging in the non banks commercial junior liens which those are always a first to see and then it makes its way into that single family.

We're also seeing an investor loans but again it creates opportunity for those who are smart, prepared note investors.

And at 70 we are watching this closely.

We do look at our strategies both manage risk and manage that upside down.

As we wrap up this episode, thanks for tuning in to the Paper Trail podcast where we follow the numbers and keep you ahead of the curve.

For more information on note investing in general you can check us out at 7e investments.com also we will be hosting the paper trail conference sept 18th to 20th in Chandler, Arizona.

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Until next time, stay alert, stay flexible in your investment strategies and keep following that paper trail.

Thank you.