No matter how bad things get, it turns out they can always get worse. Wall Street is about to foist a new “innovation” on investors that even the ratings agencies won’t touch.
Greedy, reckless, and just plain lazy mortgage originators, servicers, and trustees took what was actually a not unreasonable idea, that of mortgage securitizations, and turned it into a loss-bomb. Remember, that movie did not have to end badly. First, participants in the private label mortgage securitization market did for the most part comply with the requirements of their contracts for the first decade plus of that product’s existence. It was their wanton disregard for their own products which have led to the chain of title mess and difficulties in foreclosing that still plagues that market. Second, securitization markets that developed later than the US market (most notably, in of all places Russia and Eastern Europe) and featured some improvements on the US template have not seen the abuses of borrowers and investors suffered here and got through the global downturn reasonably well. However, the sell side has completely refused to implement the sort of reforms necessary to make the product safe for investors. So the US mortgage is and is likely to remain on government life support for the next decade.
So what have the “innovators” decided to do? Foist an even worse product on hapless investors. Remember, mortgage securitizations in concept are a decent idea and with proper protections, fees, and incentives, can be a useful and attractive product. Securitizing rental income streams for a large number of single family homes is a completely different proposition. The concept is clearly still being fleshed out, since a story on it in Reuters was unclear as to whether the “bonds” would also be entitled to the proceeds of the eventual sale of the house. I imagine that the private equity investors who are targeting this market are pushing for that, since fobbing off the problem of the home sale to the securitized vehicle is tantamount to a full cashout. They’d get initial tenants in, no matter how good or bad, and effectively flip the house to the securitization.
The newly-found convervatism of the ratings agencies may (stress only may) put a damper on this market. The ratings agencies are not willing to rate the initial deals, and want to see some history before they hazard a rating. Even then, some regard this product as sufficiently risky so as not to merit high ratings even if it were to become established. From Reuters:
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.
Moody’s issued its first report on the subject on Thursday, but said that since it had not seen a formal proposal yet, it was too early to tell exactly what rating it would assign a transaction. However, it noted that even extra credit enhancement would not mitigate a lack of historical rental-payment data, and therefore some transactions might not merit top grades.
“We would like to see the specific underwriting criteria that the operator is using to choose these tenants,” Kruti Muni, a Moody’s analyst, told IFR.
“Obviously the operators would rely on income information, the existence of security deposits, history of utility payments, etc. The diversity of the geography of the pools of homes is significant as well.”
Moody’s also said that before assigning a rating, it would need to know detailed information about the operator, and would conduct a review of the operator’s performance, its experience and its ability to perform its role in the transaction, which includes determining tenant default rates and re-leasing periods.
As Dave Dayen notes:
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…
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.
To amplify Dayen’s concerns, this looks like an effort to fob risk off onto yield-despterate investors. Rental markets are tight now, precisely due to how many homes are behind held in REO inventories or have had the homeoweners leave, yet the servicer had not actually had the trust take title to the home. But those former owners need housing, so we have a real estate version of musical chairs, with families looking for rentals before the forecloses homes have been converted to rentals. Once the conversion process is further along, it isn’t hard to imagine that rent rates will be lower in many markets and vacancy periods will be longer. Similarly, some homeowners lost their houses due to financial stress. Some of them may not even be able to make their rent payments reliably. We saw how in the 2006-2007 period, mortgage were securitized even when the borrower had defaulted in the first three months. It isn’t hard to imagine that we will see equally weak tenant rental streams sold into these securitizations.
The other looming horrorshow is, if you think mortgage servicers were unresponsive, consider how bad rental securitization servicers are likely to be. Their incentives will be to delay in responding to tenant problems in the hope that the tenant will spend the time and money required. And God only knows what happens if they apply payments incorrectly, a not-infrequent problem. One difference here is that mismanaged rentals pose a threat to the home value of the neighbors, and here, the local community does have some recourse, in that it can impose minimum rental standards, which would provide tenants with some recourse. If some communities were to go that route, it might lead to enough uncertainty regarding rental costs and income so as to deter the ratings agencies from ever assigning ratigns, which would presumably limit the size of this product considerably.
As with mortgages, the impulse of the financial community is to find even more ways to skim fees off the top of income streams and leave investors holding the bag. And if investors are dumb enough to be fooled again, after the disaster of mortgage securitizations, they will have gotten what they deserve.