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How Not to Profit From the Mortgage Crisis

Where some see wrecked debt markets, others see opportunity. Plenty of people -- Fools included -- are looking for ways to make money from the subprime crisis. Yet despite the fact that a lot of investments have gotten beaten down, you still have to be a discriminating bargain shopper.

One type of mortgage-related investment that gained popularity over the past several years is the trust deed. Billed as a way to take advantage of the explosive housing market, buying a trust deed essentially turns you into a private mortgage lender -- with all the risks and rewards that come with it.

For the most part, a trust deed is like a mortgage. From the investor's perspective, trust deeds look like bonds. In return for your investment, you receive regular interest payments for a period of time. At maturity, you get your principal back. If your borrower defaults, then you usually have the right to sell the property to recoup your investment.

High income -- at a price
What made trust deeds attractive in recent years were the high yields they offered. In an interest rate environment that left savers struggling and compressed even junk-bond yields to unprecedented lows, trust deeds were some of the only investments offering attractive returns to fixed-income investors.

As you'd expect, however, these high rates came with risk. In many cases, trust deed investors were second or third in line behind traditional borrowers. Because traditional lending standards were so loose, most borrowers took advantage of more attractive terms. Trust deed investors were left with those who couldn't get conventional loans or who needed additional financing beyond what they could get from banks and other financial institutions.

Managing your risk
But that doesn't mean all trust deeds are equally risky. Just like any loan, you have to evaluate your borrower and the loan collateral. If a trust deed is secured by property worth far more than the value of outstanding loans, then you have a margin of safety even with declining home prices. Many borrowers, such as developers, have track records that give investors a sense of how trustworthy they are.

Some money managers have tried to carve out pools of trust deeds that are relatively safe. For instance, the Lone Oak Fund specializes in bridge loans on commercial properties with maturities of as little as 30 days or as long as 24 months. Currently charging 9.9% interest, the fund only makes loans when it's first in line to collect if there's a default. Open only to qualified investors, the fund uses investments from high-net-worth individuals and institutions to make loans up to $15 million. Despite their best efforts, however, even Lone Oak's professional managers haven't managed to avoid defaults entirely.

Rolling the dice
At the other end of the spectrum, you can find second and third trust deeds paying much higher interest rates. The trade-off is that you're less likely to recover all your money if there's a default, because there are other lenders who'll get repaid before you get a penny. With real estate prices falling in many areas, that's a real risk. When you add in the potential for fraud, you have to be very careful picking your investment. The wrong choice can give you problems similar to those facing big institutions like Bear Stearns (NYSE: BSC  ) , along with lenders like Countrywide (NYSE: CFC  ) , Washington Mutual (NYSE: WM  ) , and the home finance arm of General Motors (NYSE: GM  ) .

It's tempting to try to profit from the irrational state of the mortgage lending market. In many cases, however, trust deeds are extremely risky. Whether the potential rewards outweigh those risks depends on exactly where you invest and how good you are at managing the credit risks of your borrower. If you're not prepared to pay close attention to your investment -- or pay a well-qualified manager to do so -- you should skip trust deeds.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 11, 2008, at 3:56 PM, WorkingStrategy wrote:

    It's nice to see Fool.com discuss this investment option (and point out the good and the bad). I currently work with a company in this space called Sterling Pacific Financial (http://www.sterlpac.com); I think they would agree completely with the notion of investing with qualified lenders/servicers instead of going it alone.

    One thing I might suggest: in the year since this was published, the trust deed landscape has changed significantly. The better trust deed investment companies have many, many more deals to select from now, given the credit crunch. At the same time, with public stocks battered, many investors are seeking income to rebuild. Given this, more investors are likely to be interested in trust deed investments -- would you consider writing/publishing an update to this article? I think it could be quite beneficial to many investors to learn more.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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