The last financial crisis can be blamed in large part on runaway securitization. Wall Street giants sliced and diced mortgage loans into bonds that they sold around the world. They claimed that they diversified the mortgage pools so that even a few defaults would not undermine the value of the securities, and they offered tranches of the bonds at a decent yield. As global demand increased for the securities, Wall Street pressured originators to close more and more loans, regardless of creditworthiness. This caused a bubble in prices. Moreover, financial innovators took the lower-tranche loans and cut them up into once-removed securities, making bets on bets on the housing market that were allegedly “safe”. We all know how this ended, and how the securitization bubble took a crash in housing prices and made it exponentially worse.
So now we’re poised to do that all over again.
As I’ve been chronicling, the housing market has been boosted by two events over the past several months, both of which have brought down supply and subsequently nudged up prices. First, banks and REO (real estate owned) holders have deliberately kept their properties off the market, restricting supply. Second and more important for the purposes of this post, institutional investors, including private equity firms and hedge funds, have begun to buy up foreclosed properties in large quantities at a discount. Over 40% of the foreclosed properties in Oakland have been purchased by investors of this type. In the near term, they plan to rent them out, creating what they believe is a fool-proof profit stream of rental payments. Eventually, I believe the plan is to flip the houses once prices rise more.
This has already raised fears about absentee slumlords, and massive redevelopment pushing out residents in these high-foreclosure areas. Now we’re learning about a second-order innovation to this process that looks curiously familiar. The investors want to package up these REO-to-rental properties and create securities out of them.
I first wrote about this a month ago.
The private securitization market for homes has been broken since 2008, and virtually no deals have gone through. But I could see the same alchemy used to prove to investors that they couldn’t lose on a mortgage-backed security put to work to prove the same thing on a rental-revenue-backed-security. They could slice the pools of rental units up into tranches to cushion the blow of missed monthly payments or vacancies, with more risk for higher return. And who knows, maybe they’ll just securitize that junior tranche into a CDO, just like during the housing bubble, and magically turn a high-risk security into a AAA-rated lock.
In other words, this is just a rerun, and the first movie ended rather badly. It was already going to be a problem for the management companies of these REO-to-rental units to have no community involvement; if they can securitize the payments and get sure revenue no matter what happens at their properties, they have even more of a reason to abandon them and act as absentee slumlords. This could also lead to all sorts of strong-arm tactics to force tenants to pay their rent that we have previously never seen before, well beyond a simple eviction after a grace period. The potential for abuse is high, because now there will be massive amounts of money on the line. And who will service the rental units for the investors? Servicers for loans haven’t exactly covered themselves in glory of late.
At the time, I thought the key would be if the rating agencies played along with this gamble, and handed out AAA ratings on these rental revenue securitizations. Reuters reports that many of the bonds are coming to market without ratings at all.
The first so-called real estate owned (REO)-to-rental securitizations in the United States may go ahead without credit ratings, as agencies ponder how to assign grades to the new and potentially risky products [...]
“There are unrated deals in the works,” said Suzanne Mistretta, a senior director at Fitch.
“Right now investor demand is focused on short-term [two years or less] unrated offerings, but by next year, we could be presented with a new rated transaction. Beyond a two-year average life, investors may want a rating.”
Over the past three months, Fitch, S&P, DBRS and Morningstar have each published initial assessments of the potential risks of the new asset class. But no agency has yet published official criteria for the product.
Fitch said that such transactions are unlikely to merit a rating above Single A — and even that would require sufficient historical rental-payment data or a solid record from the property’s operator/manager.
It’s simply incredible that, even with so many variables involved, Fitch would give these deals something even as high as single-A. You need data on default rates, vacancy periods, the impact of local economic forces on rentals, the various property managers and operators who would be handling the rental units in the deal, etc., etc.
Nonetheless, Wells Fargo and other banks are moving forward with unrated products that will probably attract some investors. And that’s just a horrifying prospect, especially if they catch on. There’s just no reason to believe that hedge funds and PE firms with no history of being landlords will be able to ensure a steady stream of revenue out of this. Moreover, one economic shock could blow up this market as easily as the housing bubble popped. We already know that the US economy is due to take a step back in 2013 at best, if not a full-blown recession as a result of the fiscal cliff. Add that into the mix with 9% unemployment or above (the expected range in the event of a recession), and suddenly hundreds of thousands if not millions of Americans fall behind on their rent. The securities start to sour. And this could become a full-blown financial crisis just like in 2007-2008.
This of course depends on whether rental-revenue securitizations become a big market. And so far the rating agencies aren’t playing ball, showing sufficient wariness. But considering how REO-to-rental has the potential to boost the housing market; considering all the stakeholders wanting to see that housing market rise; and considering the global economic slowdown, the associated low interest rates, and the need for large investors to get a yield on their fortunes, it’s not out of the realm of possibility that these REO-to-rental bonds catch on. And that just adds a whole other layer of risk to the system, in completely predictable ways.