A Fix Already in Place for Housing Finance?

photo byy George Becker

Executives at Pimco, the world’s largest bond fund manager, have posted U.S. Housing Finance Reform: Why Fix What Isn’t Broken? I think their analysis is interesting, but seriously flawed:

The topic of housing finance reform has come in and out of focus on Capitol Hill since Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) were taken into conservatorship back in 2008. As one of the largest participants in the mortgage-backed securities (MBS) market, and given our fiduciary role as a steward of other people’s assets, we at PIMCO are devoted to a liquid and stable mortgage market. Not surprisingly, we have taken a keen interest in the various reform proposals introduced over the past several years.

Housing finance reform need not be revolutionary

While we have refrained from commenting on specific plans, we believe housing finance reform must be comprehensive, above all else. And while we agree with a focus on shrinking the government’s role in housing finance, we believe similar attention must be paid to a responsible and thoughtful rebuilding of the private mortgage market – the alternative to the government balance sheet.

When it comes to the GSEs, we think policymakers should take a “do no harm” approach to reform that contains several key elements:

  • An explicit government guarantee for both future and legacy MBS
  • A continuation of the national mortgage rate (e.g., a borrower in Spartanburg, SC, can access a similar mortgage rate to a borrower in San Francisco, CA)
  • A guarantee fee that is counter-cyclical (versus a pro-cyclical, floating fee)
  • A continuation of the GSEs’ current credit risk transfer (CRT) program
  • Loan limits transitioned thoughtfully to be based on income levels, not housing prices

So far, so good. But they continue,

What you do not hear PIMCO calling for is a wholesale change or even an end to the status quo for Fannie Mae and Freddie Mac. Indeed, from our perspective as a large market participant, the delivery of mortgage credit has never been so efficient or so fair, nor has the market for MBS ever been so deep, liquid and stable as it has been during the years that Fannie and Freddie have been under conservatorship. What’s more, the Federal Housing Finance Agency (FHFA)’s heightened oversight has put an end to the pernicious activities that gave rise to the GSEs’ conservatorship – namely, buying subprime private-label securities collateralized by poor-credit-quality loans and putting them on their balance sheets – thereby mitigating the threat they pose to taxpayers.

The authors call for the formal “folding” in of Fannie and Freddie into the U.S. government. This would result in the Ginnie-fication of Fannie and Freddie, converting them to a government instrumentality that would be subject to the whims of the congressional budgetary process. That has not worked out so well for Ginnie Mae which has suffered from antediluvian technology and operational challenges for much of its history. Fannie and Freddie have historically been far more innovative and responsive to changes in market conditions than Ginnie. We should expect to lose those characteristics if the two companies were nationalized.

There is certainly an argument for keeping part of Fannie and Freddie’s existing operations within the federal government. But keeping the whole thing there will cause a new set of problems that we will likely bemoan a few years down the line. This proposal may appear to be a bright idea on first glance, but if you look at it the cracks show right away.

New Landlord in Town

Lionel Barrymore as Mr. Potter in "It's A Wonderful Life"

Lionel Barrymore as Mr. Potter in “It’s A Wonderful Life”

Bloomberg quoted me in Wall Street, America’s New Landlord, Kicks Tenants to the Curb. It opens,

On a chilly December afternoon in Atlanta, a judge told Reiton Allen that he had seven days to leave his house or the marshals would kick his belongings to the curb. In the packed courtroom, the truck driver, his beard flecked with gray, stood up, cast his eyes downward and clutched his black baseball cap.

The 44-year-old father of two had rented a single-family house from a company called HavenBrook Homes, which is controlled by one of the world’s biggest money managers, Pacific Investment Management Co. Here in Fulton County, Georgia, such large institutional investors are up to twice as likely to file eviction notices as smaller owners, according to a new Atlanta Federal Reserve study.

“I’ve never been displaced like this,” said Allen, who said he fell behind because of unexpected childcare expenses as his rent rose above $900 a month. “I need to go home and regroup.”

Hedge funds, large investment firms and private equity companies helped the U.S. housing market recover after the crash in 2008 by turning empty foreclosures from Atlanta to Las Vegas into occupied rentals.

Now among America’s biggest landlords, some of these companies are leaving tenants like Allen in the cold. In a business long dominated by mom-and-pop landlords, large-scale investors are shifting collections conversations from front stoops to call centers and courtrooms as they try to maximize profits.

“My hope was that these private equity firms would provide a new kind of rental housing for people who couldn’t — or didn’t want to — buy during the housing recovery,” said Elora Raymond, the report’s lead author. “Instead, it seems like they’re contributing to housing instability in Atlanta, and possibly other places.”

American Homes 4 Rent, one of the nation’s largest operators, and HavenBrook filed eviction notices at a quarter of its houses, compared with an average 15 percent for all single-family home landlords, according to Ben Miller, a Georgia State University professor and co-author of the report. HavenBrook — owned by Allianz SE’s Newport Beach, California-based Pimco — and American Homes 4 Rent, based in Agoura Hills, California, declined to comment.

Colony Starwood Homes initiated proceedings on a third of its properties, the most of any large real estate firm. Tom Barrack, chairman of U.S. President-elect Donald Trump’s inauguration committee, and the company he founded, Colony Capital, are the largest shareholders of Colony Starwood, which declined to comment.

Diane Tomb, executive director of the National Rental Home Council, which represents institutional landlords, said her members offer flexible payment plans to residents who fall behind. The cost of eviction makes it “the last option,” Tomb said. The Fed examined notices, rather than completed evictions, which are rarer, she said.

“We’re in the business to house families — and no one wants to see people displaced,” Tomb said.

According to a report last year from the Harvard Joint Center for Housing Studies, a record 21.3 million renters spent more than a third of their income on housing costs in 2014, while 11.4 million spent more than half. With credit tightening, the homeownership rate has fallen close to a 51-year low.

In January 2012, then-Federal Reserve Chairman Ben Bernanke encouraged investors to use their cash to stabilize the housing market and rehabilitate the vacant single-family houses that damage neighborhoods and property values.

Now, the Atlanta Fed’s own research suggests that the eviction practices of big landlords may also be destabilizing. An eviction notice can ruin a family’s credit and make it more difficult to rent elsewhere or qualify for public assistance.

Collection Strategy?

In Atlanta, evictions are much easier on landlords. They are cheap: about $85 in court fees and another $20 to have the tenant ejected, according to Michael Lucas, a co-author of the report and deputy director of the Atlanta Volunteer Lawyers Foundation. With few of the tenant protections of places like New York, a family can find itself homeless in less than a month.

In interviews and court filings, renters and housing advocates said that some investment firms are impersonal and unresponsive, slow to make necessary repairs and quick to evict tenants who withhold rent because of complaints about maintenance. The researchers said some landlords use an eviction notice as a “routine rent-collection strategy.”

Aaron Kuney, HavenBrook’s former executive director of acquisitions, said the companies would rather keep their existing tenants as long as possible to avoid turnover costs.

But “they want to get them out quickly if they can’t pay,” said Kuney, now chief executive officer of Piedmont Asset Management, a private equity landlord in Atlanta. “Finding people these days to rent your homes is not a problem.”

Poor Neighborhoods

The Atlanta Fed research, based on 2015 court records, marks an early look at Wall Street’s role in evictions since investment firms snapped up hundreds of thousands of homes in hard-hit markets across the U.S.

Researchers found that evictions for all kinds of landlords are concentrated in poor, mostly black neighborhoods southwest of the city. But the study found that the big investors evicted at higher rates even after accounting for the demographics of the community where homes were situated.

Tomb, of the National Rental Home Council, said institutional investors at times buy large blocks of homes from other landlords and inherit tenants who can’t afford to pay rent. They also buy foreclosed homes whose occupants may refuse to sign leases or leave.

Those cases make the eviction rates appear higher than for smaller landlords, according to Tomb, whose group represents Colony Starwood, American Homes 4 Rent and Invitation Homes. The largest firms send notices at rates similar to apartment buildings, which house the majority of Atlanta renters.

Staying Home

Not all investment firms file evictions at higher rates. Invitation Homes, a unit of private equity giant Blackstone Group LP that is planning an initial public offering this year, sent notices on 14 percent of homes, about the same as smaller landlords, records show. In Fulton County, Invitation Homes works with residents to resolve 85 percent of cases, and less than 4 percent result in forced departures, according to spokeswoman Claire Parker.

The Fed research doesn’t say why many institutional investors evict at higher rates. It could be because their size enables them to negotiate less expensive legal rates and replace renters more quickly than mom-and-pop operators.

“Lots of small landlords, when they have good tenants who don’t cause trouble, they’ll work with someone who has lost a job or can’t pay for the short term,” said David Reiss, a Brooklyn Law School professor who specializes in residential real estate.

Replacing Rating Agencies

Although rating agencies have been the subject of much criticism, including much from yours truly, (here for instance) there is no clearly superior replacement for the existing business model.  Even worse, there is not even much theoretical work on alternatives. Thus, it is exciting to see that Becker and Opp have posted a new paper, Replacing Ratings, that at least considers a plausible alternative.

Their paper examines “a unique change in how capital requirements are assigned to insurance holdings of mortgage-backed securities. The change replaced credit ratings with regulator-paid risk assessments by Pimco and BlackRock.” (1) But their analysis did not “find evidence for more accurate inputs to regulation.” (3, emphasis removed) Indeed, their “empirical analysis reveals that the old system was better able to discriminate between risks. As a result, the old system based on ratings not only provided higher levels of capital, but also ensured that capital was more appropriately related to risks.” (3-4)

By the end of their analysis, they believe that “the new system only recognizes current (expected) losses, but does not provide any buffer against possible future losses. Our results are consistent with regulatory changes being largely driven by industry interests.” (21)

They find the new system is worse than the old system and that the new system benefits the industry.  So why should we care about this research at all?  For at least three reasons:

  1. it identified a change in the insurance industry that has implications way beyond that industry;
  2. it compared how two different MBS evaluation systems performed; and
  3. it identified the drawbacks of the new system.

This is how we begin to build a body of knowledge about “viable alternatives to ratings.” (2) But, of course, there is much more work to be done.