Q3-11 Situation Analysis
Elizabeth Duke, a Governor of the Federal Reserve Bank of Richmond, spoke on September 1 in support of turning bank-owned homes into rentals. She said that “weak demand [for] owner-occupied housing [and] relatively high demand [for] rental housing suggest that transitioning some REO properties to rental housing might benefit both markets.” Ms. Duke was apparently contemplating participation by private enterprise when she pointed out that a rental housing program would have to be scaled so that participants could operate economically within their respective geographies. She also expressed wariness that neighborhoods at risk of blight from excessive foreclosure should not simply be subjected to the equivalent blight of rundown rental homes.
- Here, Ms. Duke is touching upon perhaps the most difficult issue of a burgeoning rental home market — property management.
At roughly the same time, Radar Logic has announced its intention to propose a more far-reaching plan to address the problem of home foreclosures. Their proposal is that banks, and particularly Fannie Mae and Freddie Mac, stop foreclosing entirely. In practical terms, this probably means that lenders would “credit bid” in every case that went to auction (i.e., all cases in which the lender does not renegotiate the debt or get a deed in lieu of foreclosure). A credit bid is equal to the fully accrued loan balance, so in effect, it will “win” the property every time — no discounts, no deliveries to the resale market.
Here, Radar Logic introduces an interesting point. They suggest that Fannie and Freddie float a securities offering backed by rental homes. Though Radar Logic gives no specifics, the implication is that a new subsidiary (let’s call it an “REO acceptance agency”) would raise money through an IPO, remove foreclosed homes from the agencies’ balance sheets, then rent the homes for cash to provide a return to investors.
- Like Ms. Duke, Radar Logic acknowledges that property management is a critical consideration. The IPO is unsalable without assurance that the homes will hold their value and provide cash flow.
Is the Radar Logic idea feasible? Can the agencies and banks issue securities (let’s call it “scrip”), backed by the long-term value of foreclosed homes and their rental cash flow? The simplified chart below reflects a generalized view of any such proposition.
|LOW RISK||HIGH RISK|
|High Return||1. Investors bid||2. Efficient market pricing|
|Low Return||3. Efficient market pricing||4. Issuers ask|
Boxes 2 and 3 fall
within the bid-ask spread, a normative range in which issuers and investors decide that their respective interests are adequately served. Securities have to sell within that range, and housing scrip might not do so. Investors will be wary of short-term risks (e.g., setting up efficient national management) and midterm risks (e.g., rent-collection and property depreciation during a prolonged economic bottom), which may suppress their bids — i.e., move them toward Box 1. True, cash is plentiful and under-deployed, but it is still generally migrating away from risk, and the financial sector has not forgotten the horrendous results of its last purchase of housing scrip (residential mortgage bonds, sub-prime and alt-A paper).
In Box 1, however, the issuer is required to retain a large share of risk (the so-called “B-piece”). From the banks’ point of view, instead of being stuck in Box 1, why not just go ahead and foreclose in courthouse auctions around the country? Box 1 does little to support home prices. But even if trading should occur squarely within the bid-ask spread, there’s no assurance that prices will hold up. If the economy fails to support rents and occupancy within an affordable cost-structure, the scrip would begin to devalue, which would not only erode the value of all hitherto non-securitized REO, but it might conceivably trigger scrip redemption and force the REO acceptance agency to sell homes. In either case, the purpose of the exercise would be compromised. Home prices would come under downward pressure, since scrip is just a proxy for
The best place to support home prices and bolster bank balance sheets is Box 4, but it isn’t an attractive investment. It will be hard to entice the market to pay for scrip at a non-discounted future value of those same homes.
Been there; done that.
Yet it’s worth wondering how to reduce the risk (support the price) of Box 4, because despite its manifest problems, housing scrip could do a lot of things that would be economically desirable for a lot of parties.
|It would reward lenders for keeping foreclosures off the market and thereby tend to stabilize prices.||Homeowners, their mortgagees and politicians seeking their votes would like that. Enhanced consumer confidence would help the economy at large and create a positive feedback loop extending all the way back to the value of the scrip itself.|
|It would support the balance sheets and liquidity of financial institutions, allowing them to trade their REO and potential REO for cash.||The Fed, the agencies, the U.S. and world banking systems, the FDIC and the Treasury Department would like that.|
|It would tend to advance the recovery of home-building and construction employment by encouraging formation of an “excess housing sink”.||The NAR, unions, builders and materialmen would like that.|
|It might finance or support a market in fixer-uppers, addressing the problem raised by Ms. Duke about blighted rental homes.||Entrepreneurs and the construction industry would like the chance to restore impaired property, either reselling it at non-distressed prices or keeping it for rent.|
So, how can housing scrip be kept sufficiently risk-free that it would remain “over-valued” against liquidation-pricing until home-price stabilization makes the scrip money-good? If the banks aren’t in a position to retain risk, who might be?
Because of the potential future value of the scrip, the Fed may very well consider it to be ideal for quantitative easing — the policy of buying up financial assets in order to support their price and to prevent undue market losses. In a long scale, time is on the side of the scrip. Whatever risks may intervene, sooner or later the economy will recover, the population will grow, people will want to buy homes, and the Fed can then sell its scrip —
presumably at a profit. If the Fed would buy the scrip (i.e., print money and give it to the banks in exchange for scrip), and implicitly commit to keep buying it, then private investors would feel safe in buying it, too. And it’s exactly the kind of asset that fits the policy of quantitative easing: relatively safe all things considered, protective of a socially critical asset class, anti-deflationary, tending to promote recovery generally and construction employment in particular, excellent for bank balance sheets and popular enough that it might be politically anodyne.
Why wouldn’t the Fed want to help the banking sector? That’s essential to its mission. Why wouldn’t it want to support long-term home values? Private homes are a $10+ trillion component of national wealth and a key factor in consumer confidence, which supports 70% of our national economy. Why wouldn’t the Fed want to accelerate home-building? Optimizing employment is one of the its core goals.
For its part, Fannie Mae would surely be keen to acquire more capital without having to ask Congress. Up to a point, Fannie could print scrip with the value of money and worth considerably more than the present value of the foreclosed homes behind it. Heck of
a deal for all concerned.
With or without securitization and years late, foreclosure resolution has finally come to the forefront of national policy discussion. In whatever form it ultimately takes, the process will involve repurposing foreclosed homes into rental stock. As most observers recognize, a national network of property managers will be required. In addition, whether or not a zero-foreclosure plan like Radar Logic’s is attempted, housing rehabilitation work will be required, because most homes will require pre-rental fix-up, and some homes will require such extensive repair that they cannot go directly into the rental pool. LANDCO finds itself well-prepared to take advantage of both key aspects of foreclosure resolution. In addition to creating our own portfolio of rental homes, our team is preparing to take on a large-scale management initiative for thousands of rentals belonging to others, and we are also initiating strategic alliances to support our capability in home-construction and remodeling. Foreclosure resolution, in whatever form it ultimately takes and by whatever financing method, is something to which LANDCO can profitably contribute.