Christopher Whalen: The single biggest question facing the mortgage space
There are no easy answers
Where do investors deploy capital in the housing sector in 2014? This is a question that a lot of institutional fund managers and private equity funds are asking.
There are no easy answers.
For the past several years, the trades in the housing sector have been a function of government bailouts and changes in public policy. Low interest rates, Basel III and the idiotic Dodd-Frank Wall Street Reform legislation created a wave of irrational investment in the real estate sector.
First came the REO-to-Rent trade, where smart, early money swooped down out of the clouds and bought foreclosed homes at pennies on the dollar from besieged banks. This was in 2010 and 2011, a time when many people still were not sure whether or not the world would end. Names such as Ochs Ziff and Oak Tree come to mind. This early smart money captured the lion’s share of the returns.
Later, in 2012, a larger, naive but still eager group of investors poured into the REO trade, throwing piles of public and private cash into a strategy that was clearly mature. About this time, the spread between REO properties and voluntary sales was closing, one reason that the visible indices of home prices began to show marked improvement. Indeed, more than half of the increase in home price appreciation or “HPA” measured by indices such as Case-Shiller in 2012 and 2013 came from the end of the REO trade, causing one of Wall Street’s smartest mortgage asset managers to ridicule “stupid money” jumping late into the REO trade.
As Reuters reported in October 2012: "Och-Ziff Capital Management Group LLC, the $31 billion hedge fund led by Daniel Och, recently told its investment partner, 643 Capital Management, that it wants to exit from the foreclosed homes business, said several people familiar with the matter."
But of course the money kept pouring into the REO trade, in part because the folks holding the bucket were being paid management and performance fees. Blackstone Group (BX) led a parade of large buy side firms into the rental trade, buying tens of thousands of homes long after the discount for REO assets had just about disappeared. Blackstone’s net yields on its occupied houses are about 6 percent to 6.5 percent, Jonathan Gray, the firm’s global head of real estate, said during a May 3, 2013 conference call with investors. Again, the Fed’s zero rate policy made managing 1-4 family rental homes seem attractive by comparison – at least at the time.
Fueled by cash raised from the equity markets, which was largely a function of the zero interest rate policy maintained by the Federal Open Market Committee, the late money spawned a series of public vehicles and real estate investment trusts designed that were designed to capture public investors into a strategy that was never really suitable. Almost as soon as the large institutional investors bought the homes, they found a way to sell the risk to investors – all the while pocketing handsome management and performance fees.
Now that a year and more has gone by and investors are starting to see that running 1-4 family residential properties is a difficult business. Names like Colony American Homes, American Homes 4 Rent, and Silver Bay Realty Trust have managed to deploy hundreds of millions of dollars into acquiring REO properties at pretty much the top of the market. Indeed, if you consider that Q2 2013 was probably the near-term top in HPA for this cycle, then most of these late arrivals were buying assets through the market top.
Of course, since most of the observers of the housing market use lagged data from the Federal Housing Administration or S&P Case Shiller, the public perception of housing prices is still decidedly rosy. After all, U.S. house prices rose 1.2 percent in the fourth quarter of 2013 according to the Federal Housing Finance Agency House Price Index, the tenth consecutive quarterly price increase in the purchase-only, seasonally adjusted index. Case-Shiller was up almost 12% during 2013.
“Home price appreciation in the fourth quarter was considerable, but more modest than in recent periods,” said FHFA Principal Economist Andrew Leventis. “It is too early to know whether the lower quarterly growth rate represents the beginning of more normalized price appreciation patterns or a more significant slowdown.” But is it really too early to know? Really?
While the REO trade may have seen its best days before 2010, the strategy of buying and servicing non-performing loans was a big winner in 2013 and looks to be again this year. Buy side firms that were astute enough to align themselves with a fully compliant special servicer could look forward to returns in the high teens, unlevered, and from a strategy that was largely uncorrelated to the financial markets.
Despite the fact that the larger commercial banks have resolved tens of billions of dollars’ worth of NPLs to date, there are still upward of $170 billion worth of distressed assets on the books of US banks as of year-end 2013, as the chart below suggests. Indeed, there may be as much as another $100 billion worth of distressed, 1-4 family assets caught inside the US banking sector in various stages of resolution. So the total opportunity in 1-4 family assets could be as much as a quarter of a trillion dollars, not including NPLs owned by HUD and the GSEs.
One of the attractive aspects of the NPL trade is that it depends largely on the skill of the servicer to maximize the value of the portfolio. This process includes the purchase of the loans, servicing and, most important, capturing any opportunities to refinance the assets once they have been modified. That last word is key because it is by keeping the borrower in the house via loan modification that the servicer can deliver the biggest value to investors. As I noted in a recent post on the Zero Hedge web site:
One of my favorite errors that you see constantly in the Big Media and from regulators like the CFPB and the State of New York is the idea that it is good business to push a home owner into foreclosure. Anybody with even the slightest idea about the world of distressed servicing knows that the law now requires that loan modification is the first order of business when a borrower gets into trouble. But apparently the folks at the CFPB and the State of New York, where it can take a creditor up to three years to foreclose on a house, have not gotten the memo. If you actually know the world of distressed servicing, there are three golden rules when it comes to a non-performing loan. First is keep the owner in the house. Second is protect the asset and make sure that maintenance, taxes and insurance are current. And third is to preserve the cash flow of the loan via loan modification, if possible. Keeping the family in the house and protecting the asset and cash flow, even with a substantial modification, is always better for the note holder, whether that is Uncle Sam or a private investor.
Another strategy that is closely related to NPLs is acquiring mortgage servicing rights or “MSRs.” Again, the investor must be paired with a fully compliant special servicer in order to access this strategy, either directly via an institutional relationship or indirectly by purchasing the stock of a publicly traded company that is involved purchasing MSRs.
Recent news reports about the State of New York holding up a transfer of loans from Wells Fargo to Ocwen Financial should not deter investors from investigating both the NPL and MSR trades. Each strategy offers attractive returns and the opportunity to access a strategy this is dependent upon the operational skill of the servicer and thus largely uncorrelated to the financial markets. But the big challenges facing investors in all of these strategies are (1) the waves of stupid money chasing these opportunities and (2) the likely direction of home prices over the next several years.
The first issue, namely waves of money chasing opportunities like REO, NPLs and MSRs, comes into play in a variety of ways. Stupid money bids up the value of assets above the level where a given strategy makes sense. Over the past several years, there have been periods when new investors wielding recently raised cash waded into markets like NPLs and moved valuations 5% or 10% higher than the fundamentals dictated. This sort of behavior makes members of the Federal Open Market Committee happy, but can seriously erode actually realized investor returns. If you have a good manager working for you, they will step back and go “no bid” when stupid money is doing stupid things in a market like NPLs or MSRs.
A related issue is what we’ll call “immoral hazard.” This is when a manager who has just raised a pile of money from public investors decides to go into the market and buy assets – REO, NPLs, MSRs, whatever – not because it is good value, but because the manager wants to earn a management fee. Again, if you have been fortunate to select a good manager, they will not play this game. But sadly a lot of the late arrivals to the party in all of these asset classes fall into this category and the investors suffer substantially inferior returns. Remember, it’s all about the management fee, right?
The second category and one that confronts everyone operating in the mortgage space is the fact that the “recovery” in the housing sector is probably over. Most of the Street analysts this writer respects see HPA flat to down in 2014 and then down small in the next few years. Short supply of homes in many markets may keep the published HPA indices relatively stable, but the fact remains that if you are a manager buying NPLs or MSRs, you need to factor flat to down HPA into your valuation and strategy assumptions.
So if you are in an auction with a bunch of stupid money who just want to put assets to work and thereby earn a management fee, do you bid aggressively – above the true value of the assets – or do you stand back and let the clown win the auction?
This is the single biggest question facing managers in the mortgage space in 2014.