Leon Steinberg, president of Steinberg Capital Co., was one of the most unusual paper investors in the country. In this interview he explains how he got into notes, why he moved away from “vanilla deals,” and why he believed specializing in niche paper was the only way to survive.
From rehabbing houses to buying paper
Q: Leon, what is your background?
I’ve been in paper for 30 years. Before that, I was in the real estate business in Cincinnati for 12 years. At one time I had a staff of 50 people, and during that time I bought about 1,000 houses, rehabbed them and sold them. That created a lot of second mortgages and land contracts.
But carrying back that paper created tremendous tax liabilities. In those days we were on an accrual method, so we had to pay tax on the paper we took back. The tax became very burdensome, and I had to find a way to dispose of my paper.
I found some people to buy it. After a while I looked at what they were doing and thought, “These guys are doing better buying paper than I am in real estate.” So I started to generate more paper and set up a corporation to buy it. Eventually I was buying paper from my competitors in the rehab business. That led me out of real estate entirely, and I became a money broker. I’ve been buying notes and structuring paper transactions since the 1960s.
In the 1970s I was also making and brokering loans. When I moved to California in the eighties, I found the state had a very good market for paper. In the mid-eighties I went national and started buying paper all over the U.S.
Four things made it possible to run the paper business on a national scale: the computer, the fax machine, overnight delivery and lower long-distance rates, including 800 numbers. In the sixties I looked into getting an 800 number, and the fixed cost was about $800 a month.
Why the vanilla deals stopped paying
Q: How have you changed the way you run your business in the past five years or so?
The note business has become so competitive and so broad that you have to specialize to survive. You have to develop niches in certain marketplaces. There is a vast market for “vanilla deals,” a term I coined, and many institutional buyers bid on those vanilla deals. But they leave the niche markets alone.
If you deal with these national buyers and your note doesn’t fit their criteria, you’re out of luck. You can’t sell it. Meanwhile, the market is full of new brokers coming out of the schools that have multiplied in the last few years. So the only way to survive is to develop different geographic areas and niche markets.
Q: Of course, the reason the institutions don’t buy niche paper is that they don’t have the investors for it.
That’s true. And most of them don’t have the know-how to underwrite these notes or know what to do with them.
Niche paper, risk and credit
Q: When we talk about niche paper, are we talking about higher risks?
Absolutely. But price mitigates risk.
Q: That reminds me of something Jim Levie told me. Sometimes people try to sell him a note and say, “The payment history isn’t very good, but that’s why we’ll sell it real cheap.” And he says, “How does my getting a big discount on the note make them pay any better?” Leon, what are some examples of these “non-vanilla” deals you specialize in?
A good example is residential seconds behind large first mortgages. Most institutional investors won’t buy these notes because they believe the risk is too great. In California they have 80-10-10s: someone puts 10% down, gets an 80% conventional first trust deed, and the seller of the property takes back a second for 10% of the price. The first mortgage is eight times as large as the second, and institutions won’t buy that note. It’s considered high-risk. We buy those all the time.
Q: Why?
Here’s our reasoning. The big risk is a small second behind a large first with a bad-credit borrower. That isn’t worth the risk, because it is doomed to fail. To buy a second behind a big first, you must have a payor with good credit.
If you buy these notes and one goes bad, you have a decision to make. Do you want to pay off the first, the elephant in front of you that’s eight times as big as what you hold? Nobody wants to stand behind an elephant unless they have an even chance of making the deal work.
When one of ours goes bad, we don’t even try to collect, because we aren’t going to pay off a first that’s eight times the size of our second. We’d end up with more money in the deal than we would ever get out of it. We walk away.
But if you go into the deal knowing the payor has a poor credit record or is overburdened with debt, it makes no sense to buy the note. It makes the risk worse. The credit drives the deal. Credit is very, very important. Bad credit plus high LTV is a formula for disaster.
Other niche notes worth buying
Q: What other kinds of paper do you deal in?
We’ll buy mobile home paper without land if the home is in a decent park. Again, what drives that is credit.
We’ll buy lease payment streams from major corporations. That’s when one company, for example AT&T, leases land or a building to another company, say General Electric or some other corporation. We’ll buy that stream under certain conditions. Mainly, we consider what event would have to happen to stop them from making the lease payments. If we can handle that, usually by taking a lien on the real estate so that a default on the lease is a default on the lien and we could foreclose, then we’ll buy the stream, in whole or in part.
Q: You also buy seconds on commercial real estate?
Yes, but we’re a little more conservative there than on residential. The LTV is important, but we’ll still buy a high-LTV commercial note in certain situations.
We also buy boat paper, where someone sells a pleasure boat and finances it for the buyer. It’s the same scenario as a piece of real estate, and again we need good credit. Any time you’re in a risk situation, you have to have good credit. It mitigates the risk, though of course it doesn’t eliminate it.
We’ll also buy notes on industrial properties, and in fact any deal that makes sense, meaning any deal that is adequately collateralized.
Q: You were the first note investor to go offshore. How is that going?
If you’re a buyer of vanilla deals, you can’t make money in the U.S. That’s why we’re buying offshore. We’re currently buying in Puerto Rico, the Virgin Islands, Guam, the Philippines and certain South American countries.
Advice for brokers: specialize
Q: You have over 30 years in this business. What advice do you have for brokers?
There’s too much competition today. There may be 10 or 15 other brokers bidding on the same deal, and in the end they all take these deals to institutional investors who pay about the same.
Frankly, I don’t think the broker has a bright future in this business unless fewer and fewer of them are competing. The only people who seem to do well in the paper business are the seminar schools, and they aren’t telling potential students the true market conditions. That’s immoral.
There’s no such thing as pie in the sky. Remember what John Houseman said in that commercial: “We make money the old-fashioned way. We earn it.” That’s the only way. I don’t believe you can make a living with vanilla deals anymore. You can make a living with them offshore, but you need the resources to do that. I’m buying vanilla deals offshore and will keep doing so. If I get the same competition offshore that I get in the U.S., I’ll go back to the niche markets.
This business is different than it was five years ago, and even different than it was three years ago. If you don’t keep up with the changes, you won’t succeed.
For one thing, the quality of the product today isn’t what it used to be. Frankly, in some cases the quality of the people isn’t what it used to be either. Money brings out the worst in people.
I mentioned the real estate business earlier. I used to buy a lot of properties through forced sales at a discount, including estate sales. I had brothers and sisters in my office who hated each other over a rotten $5,000, $6,000 or $10,000. They wouldn’t speak to each other. Once I gave a family their money, they left my office and got into a fistfight right in front of my building. What people will do for money is unbelievable.
To sum up: you have to specialize. Find a niche market, or several, and become an expert in it. That’s the only way to survive in this business anymore.
