New Rental Securitization Deal Likely Heralds Double Dip in Housing – Shah Gilani

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Editor’s Note: This morning, JPMorgan Chase, Deutsche Bank, and Credit Suisse will begin pitching the first-ever bond backed by U.S. home rental cashflows – a $500 million trade for Blackstone, a huge private equity firm. The road show begins with investor meetings in New York, and then moves on to Boston and Los Angeles before wrapping on Friday. This is a game-changing event, according to Shah. We wanted to share his analysis with you today, as the banks make their pitch, because of this deal’s massive implications…

Today, in New York, investors will be pitched the first-ever REO-to-rental securitization deal. The $500 million deal bundles foreclosed single-family homes, “real-estate-owned” by Blackstone Group L.P. (NYSE: BX) , into securities that pass-through rental payments to investors.

The new securitization of rental properties comes at a time when home prices have rebounded dramatically across the country. But rather than confirming a bull market in housing, the “trade,” as Reuters calls the transaction, likely heralds a coming double dip.

The upward trajectory of housing prices, fueled by private equity companies and hedge funds’ cash purchases, now faces institutional liquidity demands – and their potential exit.

Here’s what the Blackstone deal is all about, why its structure is problematic, how the ratings agencies will view it, and what it portends for the future.

This is a very big deal…

A New Way to Cash In on Housing Inventory

Blackstone Group, the world’s largest private equity company, has since 2009 spent approximately $7.5 billion buying close to 40,000 foreclosed single-family homes across the U.S. While Blackstone is the largest owner of single-family homes purchased to rent, they are by no means the only institution heavily invested in this “trade.”

Hedge funds and private equity companies stepped into the depressed housing market as banks and other institutions looked to offload huge inventories of foreclosed homes while mortgage lending standards and the Great Recession boosted interest in the rental market.

Blackstone’s Invitation Homes unit rents out its properties that, according to sources familiar with Blackstone’s purchases in areas such as Tampa and Phoenix, are typically three-bedroom, two-and-one-half bath homes averaging approximately 1,900 square feet.

The Invitation Homes 2013-SFR-1 securitization deal is structured as a real estate mortgage investment conduit (REMIC). REMICs are the preferred structure of mortgage-backed-securities (MBS) and collateralized debt obligations (CDO).

REMICs offer tax advantages, and they define mortgage-backed securities’ offerings and “permitted investments” – including cash flow investments, qualified reserve assets, and foreclosure property – as a sale of assets. This effectively removes the loans from the originating lender’s balance sheet, as opposed to debt financing, in which loans and property remain as balance sheet assets.

Now, here’s where things get interesting.

REMICs Are Legal Pyramid Schemes

There’s a lot to a REMIC, but suffice it to say that, as a type of special-purpose vehicle structure, if their AAA ratings (which many “vintage” MBSs and CDOs once proudly waived at investors) are downgraded, they can easily be put into another trust, sliced into at least two parts, and have a substantial portion of the “re-REMIC’s” securities again rated AAA.

What’s interesting about the Invitation Homes securities is their one purported AAA rating.

The deal is expected to be rated by Kroll, Morningstar, and Moody’s. Moody’s may bestow the coveted AAA investment-grade rating on the issue, because homes in the portfolio have been secured by individual mortgage liens – as opposed to an equity pledge by the property-owning special purpose vehicle (SPV).

Any AAA rating is even more interesting, given one senior structured-credit portfolio manager’s comments to Reuters on rating the first-ever REO-to-rental deal. He said, “Almost every ratings agency out there came out with criteria reports or commentaries this year saying an inaugural deal cannot get to Triple A. They said it would be Single A at most. It doesn’t make sense, the agencies drew that line in the sand; they’re on the record.”

And, most interesting of all is that the REMIC structure allows issuers to re-REMIC thousands of downgraded REMIC-structured MBS pools into larger pools and again slice them into at least two tranches whereby lower tranches subordinate prime tranches, giving them a AAA rating yet again.

While that looks like – and essentially is – a kind of pyramiding, it is legal and sanctified.

This is because re-REMICing allows banks and other financial institutions to hold formerly downgraded securities (that they otherwise would have to account for as impaired or sell at a loss) as – presto change-o! – AAA-rated securities with significantly lower reserve requirements. It’s not that re-REMICs don’t then get downgraded – they do – but the game can be played over and over.

That’s another reason the Invitation Homes deal is structured as a REMIC: It can always be re-REMIC’d.

No one expected Blackstone to pony up billions in cash from its institutional investors – including a $2.1 billion loan syndicated by the Invitation Homes lead underwriter Deutsche Bank – and not find a way to monetize its holdings. Blackstone’s equity is leveraged by debt – very cheap debt thanks to the Federal Reserve’s quantitative easing program.

Before costs for fixing up homes, insurance, taxes, and vacancies, Blackstone’s new deal probably translates into rents that yield 6% to 8%. And, on a leveraged basis, it could yield Blackstone a return in the low teens – perhaps well above 20% – if portfolio homes appreciate handsomely.

But don’t count on that.

Are the Rats Leaving the Sinking Ship?

Other players in the game have already exited the “trade,” citing too much cheap money chasing the same trade, bidding up home prices to unsustainable levels along the way.

Och-Ziff Capital Management, a $32 billion hedge fund – and one of the first entrants into the buy-to-rent market – exited the whole business last October.

Carrington Mortgage Holdings, a division of Carrington Capital, is paring back its expectations and purchases.

Citing the influx of institutional money-chasing deals that are bringing down net returns, Carrington Mortgage’s Executive Vice President Rick Sharga recently said, “It’s not surprising that some investors may have overestimated rental returns. If you’re an investor getting into this cold you were probably making assumptions based on models rather than experience.”

Meanwhile Carrington’s CEO Bruce Rose, one of the pioneers in bringing hedge funds like Oaktree Capital Management in as partners, is now saying, “We just don’t see the returns there that are adequate to incentivize us to continue to invest.”

And as recently as last June, Colony American Homes, another big player in the REO to rental space, pulled its IPO based on lackluster demand for its share offering.

Now that institutional buyers have bid up foreclosed homes and, in what amounts to a short-squeeze, ratcheted up home prices around the country, the questions to ask are: Is the recovery sustainable? Can home prices firm up at current levels and go higher? Is there underlying demand to support the rise in prices caused by institutional demand pull?

The short answer: Probably not.

With regard to “growth being propelled by institutional money,” Fitch Ratings’ analyst Suzanne Mistretta says, “The question is how much the change in prices really reflects market demand, rather than one-off market shifts that may not be around in a couple of years.”

In a couple of years?

Institutional buyers are looking for the exit doors now.

With FICO scores dropping from foreclosure proceedings, high structural unemployment, and no meaningful jobs growth on the horizon, REO-to-rental business models had better model factors like tenants’ employment prospects and desire to maintain – even if they stop paying rent – properties where they have no skin in the game.

It’s not inconceivable that some of the $10 billion in REO-to-rental deals estimated to be in the pipeline over the next 18 months could see significant credit events causing their ratings to be lowered, especially if they are AAA to start with. We’ve seen that movie before and we know how it ends.

What makes me believe the rebound in home prices is unsustainable is that the once-popular, easy-money loan programs like exotic interest-only loans, negative amortizing loans, Pay Option adjustable-rate mortgages, and all the rest of the loan products that made buying a home possible are gone. And in their place are the tried and true, old-fashioned, fixed-rate 15- and 30-year maturity, plain-vanilla mortgage loans. And most of those require 20% down and are doled out grudgingly – at best.

There are far more negative questions than optimism on the housing horizon: Where’s the new mortgage money going to come from? How hard will it become to get a mortgage? What if Fannie and Freddie are dismembered?

As Yogi Berra famously said, “When you reach the fork in the road, you take it.”

I’m taking the path of least resistance and lining up my negative bets. It’s almost time again.