Consumer Asset Backed Lending

Distressed debt opportunities in manufactured housing

John Gilfillan & Soondra Appavoo, PSource Capital

'Banks don't lend anymore.' A sweeping statement but one that needs further clarification. "Banks don't lend from their balance sheet anymore, if they can help it.

"There is evidence to suggest that banks will lend to markets where the risk can be sold off balance sheet (MBS, CLO, CDO etc) but they are less inclined to lend to sectors where off balance sheeting is difficult (i.e. the manufactured housing sector). One of the reasons for this sea change is Basel II. This directive has placed significant constraints on banks, the impact of which has been felt by a number of specialist credit areas such as lending to growth companies, trade finance and lending to manufactured housing. The graph below clearly shows that US banks now lend much less to the commercial sector in general. In 2000, lending as a proportion of assets peaked at around 17% of assets. In 2006, the level was a mere 10%.

The impact on lending to the manufactured housing sector was even more dramatic. In the 1990s, most big banks (i.e. JP Morgan Chase & Citigroup) lent to the sector, now there are two national lenders.

At the same time there has been a dramatic growth in absolute levels of lending particularly to areas like credit card borrowers, leveraged buyouts and mortgage loans, where there is a ready securitisation market.

These changes to the global banking market (especially in the US) have created a vacuum which entrepreneurial financiers and hedge funds have been able to exploit. Specialist lending opportunities now exist in corporate lending; trade finance; property finance; consumer finance and bridge finance. Hedge funds have been established which exploit all of these areas. Readers may be familiar with PIPES (Private Investment in Public Equities) which combines credit with equity investing. The asset backed lending strategies which we are discussing obtain strong returns without the volatility or risk associated with PIPES. Net returns in these specialist lenders are comparable or better than other mainstream hedge fund strategies (typically 10%-20%), but with lower volatility (typically 2%-5%).
 

Manufactured housing

Between 1.2m-1.5m manufactured homes change ownership each year which equates to a market value in the region of $30bn-$40bn. Manufactured housing has become a discrete and independent part of the US housing market for low income families with an average new sales price of $63,000 and an average second hand price of $24,000.
 

What Is manufactured housing?

Manufactured housing, originally called trailers, refers to a specific type of factory built housing that has been constructed and manufactured according to US Housing Regulations.
 

Industry History

Modern day manufactured housing came to the fore after World War II. Soldiers returned to the US only to find housing in short supply. Manufactured homes provided a cheap and quick solution; and being mobile, enabled the families to travel where the jobs were. The industry grew substantially in the 1980s and 1990s due to:

Affordability: The average sale price of a new manufactured home is $63,000 (excludes land). This is mainly attributable to the efficiencies of the factory process.

Migration: During the 1990s, immigrant population in the US grew by 11.3 million, faster than at any other time in the country's history

DemographicsThe manufactured housing market is occupied by those demographic groups who are generally on the fringes – the young but moresignificantly the old. Over 40% of all residents in this sector are aged 50 or greater. Approximately 80% earn less than $50,000 with the median income being $28,000. Despite these statistics, over 55% of residents are in full time employment.

The late 1990s proved to be a key turning point in the industry. Supplies of new manufactured homes reached a high in 1998 of 373,000; such heights had not been seen since 1973. However, in the rush to service the increased demand, credit controls were not strictly adhered to and a fall out followed in 2002. At the same time, historically low interest rates ensured that mainstream housing became more affordable to traditional buyers of manufactured houses.

To those investors that buy existing portfolios of debt however, the reduction in the shipment of new homes is not a key consideration. The key consideration is that the overall market (both new and second hand) is still growing and in absolute terms the market is very large.
 

Why Banks Don't Lend To The Manufactured Housing Sector?

We would argue that banks don't lend to the sector for three reasons:
– poor lending in the 1990s scared them off
– the impact of the new banking revisions (Basel II)
– the specialist nature of debt management in the sector
 

Poor Lending in the 1990s

The financial problems and subsequent application for Chapter 11 protection by Conseco in 2002 left some of the company's creditors with bloodied noses. Among them were blue chip names such as J.P.Morgan Chase, Bank of America and Lehman Brothers. After such a painful experience, banks were quick to withdraw from this sector and have been slow to return.

The downfall of Conseco's subsidiary, Green Tree Financial Corporation, was brought about through an unexpectedly high rate of refinancing by its customers. In an environment of falling interest rates, Green Tree incorrectly calculated the number of assumed prepayments that customers would make. Consequently, the company received fewer interest payments. In addition, an increase in the level of defaults brought about through poor lending decisions and a lending program that only required a 5% down payment added to the pain when the prices of second hand homes began to fall in value. The company had a $17bn portfolio of loans on which it defaulted on $4bn. Conseco were not alone. Slack credit controls from 1990-2000 led to a boom in manufactured housing but ultimately contributed to an increase in loan delinquency (see Fig.4) and foreclosure. The graph clearly shows that delinquency rates have reverted to their long run average of approximately 3%, which is good news for those who still lend to this sector.
 

Basel II

Basel II has also imposed significant requirements on banks. In addition to maintaining the need to hold total capital equivalent to at least 8% of their risk weighted assets, the committee has increased the risk sensitivity of certain variables – credit, operational and market risk. The relative weight that is now attributed to certain variables has meant that banks are less keen to pursue lending opportunities in certain sectors because of the impact it has on their capital adequacy measures. If a liability can't easily be removed from the balance sheet, banks are less inclined to get involved in that type of lending.
 

Debt Management

The ability of lenders to capitalise on this current opportunity rests firmly with their ability to have effective credit controls in place. The debt management process is key to the success or otherwise of lenders to this sector. Debt management requires a highly skilled team but once in place, it is very difficult to replicate and serves as a barrier to entry. Whilst there are numerous banks that couldinvest money in this sector overnight, sub prime debt secured on manufactured housing is not standard and banks are not particularly good at managing non-standard debt. Engaging in conversation with the less affluent about monthly cash flows is not the remit of most mainstream banks.
 

Who Does Lend To The Manufactured Housing Sector?

At the time of writing there are only two national lenders to this sector. Vanderbilt Mortgages, a subsidiary of Warren Buffet's investment vehicle Berkshire Hathaway; and a Michigan based REIT, Origen Financial. Home manufacturers and trailer park owners also provide finance. However, as lending is not their main business they are often keen to sell their debt book to investors, thus providing investment opportunities.
 

Track Record of Existing Fund | Performance Net of Fees
  JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC ANN.
2005     1.50% 2.53% 1.93% 1.79% 2.55% 0.56% 1.24% 0.95% 1.05% 0.80% 15.92%
2006 0.92% 0.85% 1.06% 0.97% 0.89% 0.85% 0.86% 0.74%         7.37%

For investors, the opportunity manifests itself in:
– the ability to buy debt portfolios at a discount
– that offer good rates of return
– together with the fact there are a limited number of market participants in what is a sizeable market.
The changes brought about by Basel II are more structural than cyclical and this would suggest that banks won't return to this sector in the near term.
 

Risks

1) Deterioration In US Real Estate Market

Manufactured housing has historically been uncorrelated with the US residential housing market, traditional equity and debt instruments. It is interesting to note that during the period 1980-2005, there have only been two occasions when the average sales price of a new manufactured home has declined. In the period 1981-82, prices dropped by 1.01%. In the period 1990-91, there was a 0.3% drop in prices. Both periods coincided with recessionary times in the United States. It is in the second hand market where prices exhibit the greatest volatility as demonstrated in Fig.5. The key to mitigating the risk if the price falls is to maintain strong collateralisation.
 

2) Changes In Interest Rates

In extremis, very high interest rates can lead to a rise in default rates. However, the interest rate on a manufactured housing loan is 'locked in' such that they are not generally susceptible to changes at a macro level. A significant fall in interest rates may result in an increase in the affordability of traditional real estate which does present a risk. But given where interest rates currently are and the direction they have been moving in, manufactured housing is likely to be a net beneficiary of current interest rate policy.
 

3) New entrants flood the market driving down returns

Recent industry problems have been self inflicted – poor credit controls and an oversupply of inventory. Lessons have been learnt from this debacle and it is clearly understood that to be successful in this area requires:
– Sensible lending practices.
– Active debt management service.
 

HOW DO YOU MAKE MONEY IN THIS SECTOR?

– A Case Study

A Colorado based fund manager, Palm Advisors LLC, have a fund that specialises in this sector. It is appropriately named the 'Palm Manufactured Housing Fund.'

This particular fund was created in March 2005 and has achieved returns in excess of 15% per annum with volatility of 2.1%. To date, the fund has suffered no down months.
 

How Have They Done This?

The two fund managers, Carl De Rozario & Kenneth Blevins have nearly four decades of experience between them in asset backed securitisations and default management. This vast experience is clearly reflected in the returns thus far.
 

Objective of the fund

* Investment objective of the fund is to achieve stable long term capital growth and significant income by investing in private loan notes secured on US manufactured housing and related securities
 

Investment Strategy

*Four types of investments:
– Manufactured Housing loans: purchase portfolios of loans issued to fund the purchase of manufactured houses
– Tax liens: purchase tax liens from municipalities
– Investments in trailer parks- Other higher yielding mortgage backed loans

* Manufactured Housing Loans(80% of the strategy):
– Core of strategy
– Typically 10-25 year secured amortising loans
– Typical IRR 20-25%

* Tax liens
– Typical IRR 10-30%

* Trailer Parks
– Lower yields, but potential for capital gains and the use of leverage
 

Key Attributes

– purchase debt at an appropriate loan to value ratio – good active debt management – short loan duration – high yields – no primary lending
 

Conclusion

In conclusion, the purchase of sub prime debt secured on manufactured housing can be a very lucrative business if the entire process is managed correctly. The inherent barriers to entry in addition to the current reluctance of the banks to lend to this sector will ensure that the window of opportunity will remain for some time yet.

What is not in doubt is that people need to live somewhere. Even in recessionary periods, families still need homes to live in and given that the manufactured housing sector is most likely to benefit from any recession, the downside risks seem to be limited.
 

The Future?

Palm Advisors LLC are working exclusively with London based manager, PSource Capital (part of the Punter Southall Group), to launch a closed ended company that will be listed on the London markets. Investors will be able to obtain direct exposure to this high yielding asset class whilst also obtaining the benefits of daily liquidity.THFJ