Bonds Draw Scrutiny Where Subprime Spread

California lawmaker draws correlations between rental bonds, which are funding investment firms' purchase of tens of thousands of rental homes, and securitization of subprime mortgages.

Mark Takano saw how subprime mortgages devastated his hometown of Riverside, California, after Wall Street helped inflate a housing bubble that burst and left a trail of foreclosures among the worst in the U.S.

Now a first-term Democratic Congressman representing a district east of Los Angeles, Takano said he worries about a repeat as banks including Goldman Sachs Group Inc. and JPMorgan Chase & Co. prepare to create securities based on the latest real estate boom: rental homes.

“We should learn from history,” Takano, 53, said in a telephone interview this week, days after he asked the Financial Services Committee to hold hearings on the bonds. “We see a similar kind of instrument now being pioneered.”

013114_Bloomberg_Pq1While Takano will find it difficult to gain traction in the Republican-controlled House of Representatives, other policymakers, regulators, and investors are increasingly scrutinizing private-equity purchases of homes across the U.S. and the potential impact on neighborhoods and homeownership. Janet Yellen, the incoming central bank chairman, said this month that the trend needs to be watched carefully, after Federal Reserve economists urged regulators to monitor the debt for signs it could damage financial markets.

Firms led by Blackstone Group LP already have spent $20 billion on as many as 200,000 houses in the last two years, according to Jade Rahmani, an analyst with Keefe Bruyette & Woods Inc., seeking to profit from rising prices and increased demand for rentals after 4.8 million homeowners lost their property to foreclosure since 2008. The homeownership rate in the U.S. has dropped to 65.2 percent from a peak of 69.2 percent in 2004.

Deutsche Bank AG led the first rental bond sale in November, raising $479 million for Blackstone’s Invitation Homes, which has spent more than $7.8 billion on 41,000 homes.

Goldman Sachs, JPMorgan, and Wells Fargo & Co. are now preparing to sell as much as $500 million in bonds for American Homes 4 Rent, the second-largest landlord, with more than 21,000 homes. JPMorgan and Credit Suisse Group AG are working with Colony American Homes Inc., a property company run by Tom Barrack that owns more than 15,000 rental houses.

Raising money in the bond market gives investors an additional source of financing as they continue to expand, targeting areas where they expect prices and rents to rise as demand for homes grows with a recovering job market. Securities backed by single-family rental home payments may reach or exceed $30 billion a year, and could create a “paradigm shift” in the housing market, Rahmani wrote in a Jan. 13 note to investors.


Crisis Memories

For Takano, a Harvard University graduate and English teacher who took a leave of absence in 2012 when he ran for Congress, it’s all too reminiscent of last decade’s financing binge.

Southern California was the birthplace of subprime lending, powered by New Century Financial Corp., Ameriquest Mortgage Co., and Countrywide Financial Corp. that offered mortgages to borrowers with low credit scores or limited documentation.

Wall Street started packaging the home loans and then sliced them into pools based on the predicted default potential, paying higher interest rates to investors in the riskier levels of debt. Investment banking fees soared as they securitized ever-riskier home loans. Lenders originated $625 billion of subprime loans in the peak year of 2005 to borrowers who often couldn’t pay the debt, according to Inside Mortgage Finance.

Securities were then repackaged into bonds known as collateralized debt obligations, or CDOs, which were assigned top credit ratings that proved unfounded when defaults soared and the housing market crashed. Rental bonds are one of the first new types of securitization since the 2008 credit crisis.

“The Street is looking for another product to sell,” James Grady, head of structured finance at Deutsche Asset & Wealth Management, said during an industry conference this month. “Back in the day we had the CDO machine, and I think they’re looking to replicate something along those lines.”

That’s raising concerns for Takano, whose district was particularly hard hit. The area east of Los Angeles was responsible for almost 5 percent of all U.S. foreclosures in 2008 and 2009, with banks repossessing almost 4,000 homes a month in the Riverside-San Bernardino metropolitan area, according to CoreLogic Inc.

By January 2010, the number of mortgages at least 90 days delinquent peaked at 18.5 percent, double the national average, CoreLogic reported. Prices in Riverside County fell 60 percent from their 2006 peak to a median $171,480, according to the California Association of Realtors.

Riverside County also was where Blackstone’s Invitation Homes bought its first house. Nick Gould, now the company’s chairman and chief executive officer, pulled into a housing tract to repair a flat tire in December 2011 and found “crazy value” in newly-built, low-priced foreclosed homes in the area.

“I could see how the market was going to progress,” Gould said in a December interview.

Blackstone began spending as much as $150 million a week on homes in cities like Phoenix, Atlanta, Miami, and Chicago. American Homes 4 Rent, Colony, Starwood Property Trust Inc., and other investors joined the buying spree. In less than two years, they’ve transformed the business of renting houses in the U.S., previously a mom-and-pop industry, into one with centralized businesses.

Politicians including President Barack Obama and Arizona Congressman David Schweikert, a Republican with experience as a landlord, praised institutional investors last year for helping to stabilize property values. Prices have jumped 24 percent from the low in March 2012, according to the S&P/Case-Shiller index of 20 cities.


Logical Market Response

Regulators should “watch this very carefully,” Yellen said of institutional investors at her Jan. 6 confirmation. “But I don’t see that as an asset bubble. I see that as a very logical response of the market to generate a recovery in very hard-hit areas.”

Home prices in Riverside County jumped 23 percent last year to a median $310,020, according to the California Association of Realtors. Institutional buyers purchased 8,208 foreclosed homes in Riverside and San Bernardino counties in 2013, said John Husing, an economist whose firm, Economics & Politics Inc., focuses on the Inland Empire area that covers Riverside and San Bernardino counties. Blackstone owns at least 457 homes in Riverside County and Colony owns 219, according to property records.

Neighborhoods built for owner-occupied homes are now dominated by rentals, a change that has led to more police calls, lower student performance, and poorer property maintenance, said Husing, who lives in Redlands, California, across the street from a vacant foreclosed house.

“You’ve got this lemon sitting in the middle of the neighborhood that’s not well cared for,” Husing said in a telephone interview. “I’m looking at a dead lawn because there’s nobody in it right now.”

The rise in foreclosures sparked a wave of crimes, such as squatters occupying vacant homes and people posing as landlords and collecting rent on homes they didn’t own, according to Vicki Hightower, chief deputy district attorney who oversees prosecution of fraud in Riverside County.

It’s possible the large landlords are helping reduce these offenses by renovating vacant properties and legitimately leasing them, she said.


Bidding Wars

Corporate landlords have said their mass purchases and renovations improve blighted areas and are providing more housing opportunities to residents in neighborhoods with good public schools.

Some of Takano’s constituents have complained the investors are making it harder to buy properties.

“They’re being outbid by much bigger players who are far more powerful, and they’re not in it to provide affordable housing,” he said.

Owning a house cost 31 percent less than renting in the Riverside-San Bernardino area last year, according to Trulia Inc. About one in three renters in Takano’s district pay half of their income for rent, making it harder to save for a down payment, according to a research report he issued last week.

Congressman Jeb Hensarling, the Texas Republican who heads the Financial Services committee, hasn’t responded to Takano’s request, and his office didn’t reply to phone messages and emailed requests for comment.

Takano isn’t the only voice expressing concern about the potential growth of rental-home bonds, with Federal Reserve economists Raven Molloy and Rebecca Zarutskie writing last month on the subject.

“Financial stability concerns may become more significant should debt financing become more prevalent or if the share of homes owned by investors in certain markets rises significantly further,” they wrote in a Dec. 5 note. “Greater use of leverage makes financial distress of the investors more likely, which may force them to liquidate their asset holdings at suboptimal values.”

Takano said he’s open to evidence that the new landlords and their financial instruments are good for the market.

“All the more reason to have a hearing if this is true,” he said.

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