Tuesday, February 19, 2008

Bankers Are Morons

For the uninitiated, here's a quick recap of how a builder gets that house built.

First, a construction loan is applied for and received. Those funds are specifically for the cost of building the house; in other words, they are supposed to pay the sub contractors for their work.

The actual process of getting the funds from the construction loan can vary depending on the bank. Some banks will wire money to the builder's bank account according to the percentage of completion of the house. Some banks require that the builder fax in a disbursement request with the sub contractor bills attached, and then they wire the money to the builder.

The only smart one of the bunch will require copies of the bills, and then write the checks themselves.

When banks write the checks themselves, they are assured that the sub-contractors are paid. However, during the heady times of the housing boom, many banks were very lax with their construction loans. Simply wiring money to the builder is in essence an honor system, leaving the banker to trust that the builder will use the money appropriately. The problem is that many builders did not. There's payroll to meet, new projects to acquire, and countless other expenses that need paying for. Money for one project is used for a project somewhere else, always with the intention that it will be paid back with funds from yet other projects. As long as the houses get built, nobody cares.

That is, until the market slows. Then the money from closings dries up and can't be used to keep the cash flowing. Building projects in turn slow down as subs aren't paid. Lien notices are filed on multiple properties, making it harder to close, and alerting the now nervous bankers to what they should have known all along. Builders are left with what could be millions of dollars of property, but little to no cash to finish building.

The bankers are angry that the builder would divert money from their project to use somewhere else. They threaten to call the loan due and take over the property; which of course they really don't want to do. Bankers are in the business of loaning money, not building condos. So instead they tighten up controls and make it harder for builders to get access to more money. But the bank might as well take the property, because by withholding cash they make it next to impossible for the builder to finish the job.

Moral of the story- bankers are morons.


Ashlee said...

Our bank just gave us a check book and when we need money to give to Brandon, we tell the bank how much and what for and they put that money into the bank account created for the construction loan and then we write a check for that same amount. If we were evil people we could just buy a really nice new sectional that we will need when the basement is finished. :0) But we're not. Basement won't ever get finished if Brandon doesn't get his money anyway.
As much as Bankers were dumb for not keeping tabs on where the money was going, the builders should have done some better bookkeeping. :0) Not bashing you here. But seriously, if they would have put the money where it was intended to go, then there wouldn't be the problems we are having now right? I don't think either side is more to blame. They're BOTH just dumb!

Cameron said...

Oh absolutely. The builder that let himself get so leveraged is a big dumb head. But at the end of the day, it's the bankers money, and they didn't do their job of protecting their investment. With even a little bit of controls in place they could have avoided the mess they got themselves into.

The housing industry is a little different than your basement project. There are multi-million dollar housing and condominium projects being built and the only way the bank will recoup their money is when the project is finished and then sold. If the money is taken for something other than to build those condos, then they'll never be sold, and the bank won't get its investment back.

Tom Scharbach said...

I practiced real estate law for twenty years, Cameron, and a smart construction lender:

(A) requires three things for payment: (1) a sworn affidavit from the builder/general contractor showing the amounts to be paid, for what, and to whom; (2) a signed waiver of lien from the builder/general contractor; and (3) a signed waiver of lien from the subcontractors to be paid; and

(B) checks the draw amounts against budget amounts to make sure that the loan remains in balance; and

(C) pays the builder/general contractor and subcontractors individually and directly, each according to the affidavit and waivers, to ensure that the builder does not divert the funds.

Builders are known to rob Peter to pay Paul as more or less customary business practice, often using money from one part of a project to fund another part of a project. Bankers who ignore this reality end up with bad loans.

Cameron said...

Tom, you are 100% correct. Smart bankers will protect their investment by requiring those few reasonable steps, and there are smart bankers out there that do. They might get some whining from builders who don't like all the hoops to jump through, but banks that held the line in this respect are much better off today than those that didn't.

I know of one quite large bank that specializes in construction lending and they do a large amount of due diligence just to extend a loan in the first place. I am quite certain that they are content with their financial position despite the chaos of the housing market.

Geoffrey Kruse-Safford said...

I would think, in light of the collapse of the housing market over the past year, that would be obvious without the legal and accounting arcana.

Cameron said...

Sure, over the last year bankers have begun to shore up these practices. But it's often too late. The trick is to hold yourself to a "strict" process during the high times when it doesn't seem to matter.