Spending and risking someone else’s money is always easier than spending and risking your own. When someone is willing to put his or her own money into play for an investment activity, it may not mean a guarantee that the activity will end up profitable, but it does show the person’s belief in the integrity of the investment.
Warren Buffet once referred to this as, “skin in the game.” He used this term specifically when referring to executives who invest their own money in the companies they run. These individuals are insiders who know their companies intimately, and are willing to risk their own skin by investing their money in the company—showing great faith in their own abilities as well as the financial potential of their company.
In terms of a hard money loan (or trust deed investment), skin in the game is an important concept because it not only shows the faith that the borrower has in the property they are buying or extracting equity from and the exit strategy they have for the loan, but it also forms an automatic cushion of collateral by reducing the percentage of the investment made by the lender.
Not only does the LTV cushion contribute to the protective equity that provides a hedge against risk, but the borrower’s investment ensures that he or she will have a vested interest in the success of their plan—which is another kind of hedge for the lender, albeit an intangible one.
So important is the concept of skin in the game to the integrity of the financial community that the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act includes a mandate that requires lenders who syndicate – mortgage loans eligible for sale to the secondary market for securitization – maintain five percent of the risk of non-qualifying loans that are thought to be higher-risk than traditional loans, thus giving financial firms a stake in the loans’ performance, or meet standards exempting loans from risk retention.
Hard money borrowers and lenders illustrate one of the most symbiotic investment relationships available today. By ponying up equal amount of skin for the game, they each show their belief in the investment and their willingness to take an equal risk for the benefit of that upside potential, giving them equal footing and increased confidence in the safety of the investment.