On September 29, 2008, the Dow Jones Industrial Average stock market index experienced the largest point drop in one day in the history of the New York Stock Exchange. This massive loss came amidst the “Great Recession” that began in late-2007, would continue into mid-2009 and would leave its destructive mark on financial markets all over the world. At the heart of this recession was the collapse of a very specific financial instrument: the mortgage-backed security (MBS). At a time when interest rates were low and investors were yearning for assets with high yields, banks began bundling together large quantities of mortgages into “collateralized debt obligations” (CDOs) and separating them into categories, known as “tranches,” based on their exposure to risk. Each tranche received a rating from a credit rating agency, with the lowest-risk tranches receiving a AAA rating, signaling to investors that they were safe investments. Investors competed fiercely to invest in these high-return and supposedly stable securities, and banks received immense amounts of leverage to keep issuing mortgages and packaging them into more and more MBS. This led to banks giving out “subprime” mortgages to borrowers who were at high risk of default, but unfortunately this high risk was not reflected by the credit rating agencies which kept giving artificially high ratings to the CDOs, because they wanted to keep attracting the business of large financial institutions.
Eventually, subprime borrowers began to default, the housing market began to collapse and the MBS market began to vanish, leading to massive financial institutions almost becoming insolvent. A windfall of financial regulation of the MBS market followed, and the market has since drastically reduced in size. However, the involvement of large financial institutions in the housing market had only just begun. Enter, the rent-backed security (RBS).
If the name “rent-backed security” scares you, don’t worry you aren’t alone. In the wake of the most recent global financial crisis, there has been debate over the role that this new financial instrument has to play and the risks that it poses. First, however, it’s necessary to understand what a rent-backed security is. In the depths of the financial crisis, large private equity firms and real estate investment trusts bought around 200,000 homes worth around $20 billion and began renting them out. The biggest buyer was private equity giant Blackstone, which snatched up around 40,000 properties valued at $7 billion through its subsidiary company Invitation Homes. In much the same manner as with MBS, RBS bundles together the rental payments from a large amount of homes, tranches the resulting security, and sells it to investors who receive the rental payments in exchange for funding the firm creating the security. The first firm to package and sell this security was Blackstone, which sold the first securitization of single-family rental homes in the fall of 2013, in the form of a $479 million bond. Unexpectedly, the highest tranche of this bond received a AAA rating by three different credit agencies, contributing to investor interest. When the bond was sold, frenzied investors eagerly bought it up, to the point that Blackstone drew six times as many investors as it could accommodate. A mere two years later, Wall Street firms had sold nearly $10 billion of these bonds, and analysis indicates that the market for RBS could grow to a trillion dollar industry. Earlier this year, Invitation Homes, the same company to first sell an RBS bond, went public and raised $1.54 billion in its initial public offering. Naturally, the question arises: What does the explosion of this new security mean for the future of global financial markets?
At a time when more and more Americans are turning to rentals over homeownership, the RBS market might be exactly what we need. Firstly, there are indications that the massive injections of capital provided by these large financial institutions helped rebound depressed housing prices and revitalize a slumped housing market. Additionally, Nobel Prize-winning economist Robert Shiller believes that a large and liquid RBS market will make the housing market more efficient and provide better pricing information to consumers. Essentially, the more buyers and sellers there are in any market reduces the difference between how much buyers are willing to pay and how much sellers are willing to sell for. Lewis Ranieri, the banker credited with the invention of the MBS, says that what these firms are doing would “fix” the broken housing market, by making risky bets and profiting from them if they pay off. Furthermore, these firms are spending millions on renovating properties that were left in shoddy condition after their previous owners evacuated during the housing market collapse. All of these factors potentially create a more fluid, dependable housing market that benefits renters and investors alike.
However, there are significant drawbacks to the RBS market. For starters, according to a report by Freddie Mac, the quantity of affordable housing fell by a staggering 60% from 2010-2016, indicating that firms are doing little, if anything at all, to help consumers access housing. In fact, according to a report by the organization Right to the City, rent payments on properties owned by Invitation Homes in three different cities were higher than the “fair market assessments” set by the U.S. Department of Housing and Urban Development for those areas. Additionally, tenants living in properties owned by institutional investors frequently complained about overly aggressive eviction notices and very little money being spent on maintenance and repairs. Both of these adverse features may be due to the fact that these institutional investors (who are the landlords of these properties) are often thousands of miles away, and therefore they have little sympathy for tenants, as opposed to mom-and-pop landlords managing just a few rentals. There’s also the inherent uncertainty that comes with rentals: maintaining a high occupancy rate is essential for these firms to make payouts on the RBS. This creates quite a bit of volatility, as shown in 2014 when the vacancy rates in Colony American Homes single-family rental homes rose 77% in just two months. The most holistic concern, however, is what the explosion of RBS means for the overall behavior of the housing market. As the capital for mortgages that is usually tied up on banks’ balance sheets becomes freed up, firms can use that money to outbid regular homebuyers who often have to get a mortgage. This will push the housing market further away from ownership and into rentals, which creates problems for millions of Americans who are trying to attain equity by owning a home.
Amidst all of these considerations, the domestic RBS market has only continued to expand. Intuitively, the federal government should be regulating the RBS market to some extent, or at the very least structuring it to avoid the pitfalls of the 2008 crisis. Regulation seems especially necessary in anticipation of an upcoming merger between Invitation Homes and Starwood Waypoint Homes, with the resulting entity controlling about 82,000 homes across the country. Unfortunately, very little engagement has come from the federal government, besides a recent probe by the Securities and Exchange Commission into whether the value of the underlying rentals has been inflated. Fannie Mae, on the other hand, backed $1 billion in debt on rental homes owned by Blackstone earlier this year before the initial public offering of Invitation Homes. This move seems to echo the activity of Fannie Mae and Freddie Mac leading up to the housing crisis, when they bought up large quantities of MBS. Internationally, the RBS market will soon expand to China, where the China Securities Regulatory Commission recently announced it would be accelerating its approval of China’s first RBS, offered by the Poly Real Estate Company and coming in at a sale value of five billion yuan ($754 million).
It seems, then, that there is no stopping the RBS market, and there’s no telling what financial heights it will reach. With proper and responsive regulation by governments all over the world, RBS could just be a player in housing markets plagued by high prices and limited supply. However, left to its own devices, the RBS market could generate so much volatility that it would potentially create a new global financial disaster, dooming us to repeat the mistakes of our past.