WHILE STEVE MNUCHIN WAS RECEIVING his windfall by flipping OneWest Bank, Tom Barrack and Steve Schwarzman were also looking to cash in by flipping their investment on tens of thousands of single-family homes. As the years passed and property values recovered, these houses were worth more and more. But Barrack and Schwarzman didn’t want to cash in the same way a traditional real estate flipper does: buying a dilapidated house for cheap, fixing it up, and selling it a few years later. Instead, they wanted to find a way to flip their investment and make a killing while at the same time hold on to the properties themselves.
Barrack’s and Schwarzman’s publicly presented business model involved charging ever-increasing rents as they pushed most of the maintenance cost onto tenants. Collecting rent, however, is a long-term play. Even if you’re able to pocket 60 cents of every dollar of rent after paying for maintenance, taxes, and other fixed expenses (as Colony was), and even if that is happening on tens of thousands of properties at a time, the returns are still gradual. They pale in comparison with the spectacularly immediate amount of money that can be made by flipping.
In short, making money on rent is boring. Schwarzman and Barrack weren’t principally in the business for the long-term returns of being landlords. They’d bought houses for the chance at hitting a jackpot, not a respectable annual return. The typical route for private equity is three to five years and then flip. But without selling the houses, how would they do it?
The first part of that equation was the creation of a new type of mortgage-backed securities; the same sort of complicated financial product that Steve Mnuchin pioneered at Goldman Sachs back in the 1980s and that later collapsed the entire global economy.
To understand how these worked, think back to Frank Capra’s It’s a Wonderful Life: in the nightmarish version of the movie set during the housing bust, George Bailey would have bundled all the home mortgages he made to the working families in Bedford Falls into giant, mortgage-backed securities and sold them on Wall Street. He would thus get his money right away instead of having to wait for years until the debt was repaid. (The buyers of the securities would be on the hook for that.) Then he could loan all that same money again to a whole new set of home buyers and do more bundling. The main way he would make money wouldn’t be from collecting interest on loans; it would be from charging fees, and he could do that again and again.
But what about Mr. Potter, who’d used the Great Depression to hoover up (no pun intended) most of the housing in Bedford Falls? Imagine if, while already owning all the houses in town and forcing his tenants to pay high rents, he also had the ability to take out a giant loan against all of those houses and then make his tenants pay back the loan. Flush with cash, he could then buy even more property, invest the money in a completely new business, or retire far from Bedford Falls—say, in a château in the South of France. That’s the product Tom Barrack and Steve Schwarzman created after they’d bought tens of thousands of single-family homes all over America.
The first one of these new securities, developed by Blackstone in October 2013, was a $479 million bundle of debt taken out against 3,207 single-family homes across five states. It was “a watershed event,” Mortgage Banking magazine declared, saying that these types of bundles could eventually be extended to 10 million homes. “The investment and lending opportunities are immense and perhaps just beginning.”1 Blackstone celebrated by throwing a bash for three hundred at the Waldorf Astoria,2 the stately Midtown Manhattan hotel where New York’s elite had gathered for their costume ball more than a century earlier. (When I asked company insiders why Blackstone announced the deal at the Waldorf, they said it was convenient. At the time, Blackstone owned the building.)
“The execution [of the debt offering] was simply superb,” crowed Richard Saltzman, president and CEO of Tom Barrack’s Colony Financial, the following week. Colony was putting together a giant debt bundle on its homes, too, he said. “All in all, this is a great time for our business.”3
EXACTLY HOW THESE transactions work is complicated and easier to explain in detail by considering a single house rather than a bundle in its entirety. Take the Butler family home in South Los Angeles, which was rolled into the first mortgage-backed security created by Colony, six months after the Blackstone deal, in April 2014.
If you go to your local county courthouse and look up any address in town, you will find the deed to that house, which is in the name of the homeowner. You can also find out how big of a mortgage the homeowner has taken out, along with details of the loan: interest rate, number of years in which to pay it off, and so on. If you look up my house in San Francisco, you will find a $338,000 thirty-year fixed-rate mortgage taken out in 2009, when we bought the house. Four years later, in 2013, you can see that, after paying down our debt slightly, we refinanced into a $324,000 fifteen-year fixed-rate mortgage, taking advantage of historically low interest rates. Taken together, the documents tell a story. If everything goes as we hope, we should own the home free and clear in 2028, the same year our oldest son goes off to college—the American Dream, as recorded at a county courthouse.
The documents recorded on the Butlers’ home tell a different story, one so complicated that I had to spend weeks on the phone talking to bond traders, real estate agents, and academics to make sense of it. The first of the documents is relatively simple and represented a ghoulish counterpoint to my happily ever after. Pulled out of a drawer in a drab concrete building fifteen miles away from the house in Norwalk, was the reverse mortgage from Financial Freedom. Then there was the foreclosure from OneWest Bank and the sale of the home for $180,000 to Colfin AI-CA5 LLC. After that, there was another document that was harder to understand. Unlike my house, which was refinanced with a loan of $324,000, the Butler home (which is about the same size) had a lien recorded against it for $513,900,000. That means the owner of the house owed someone $514 million. If they didn’t pay it back, the lien meant that the lender had the power to take the house.
Of course, the Butler home wasn’t worth $514 million—nowhere near it. But that was the value of the lien recorded against every single house in the bundle, including the bungalow. The 144-page loan document created a business relationship between the new owner of the house, CAH Borrower 2014-1 LLC (a wholly owned subsidiary of Colony, chartered in Delaware) and JPMorgan Chase, the international banking giant. Chase was listed as the beneficiary, meaning that it provided the $514 million and could take all the houses in the bundle if Colony—or, more correctly, CAH Borrower 2014–1 LLC—didn’t pay back the money. Interestingly, the loan wasn’t only backed up by the houses themselves but also from the rent tenants would be paying on those homes.
After thirty-six pages of legal language and a seal from a notary, the remaining 107 pages are a list of addresses of Los Angeles County homes that were part of the deal. Similar documents were filed in courthouses the same day in Las Vegas, Phoenix, and Atlanta. Each deed of trust gives JPMorgan Chase the right to either seize the houses or simply collect and keep the rent for itself if anything goes wrong. All told, the number of homes “securitized” in the deal—in other words, that JPMorgan Chase could take if the loan went bad—was 3,399.
According to the Kroll Bond Rating Agency, Tom Barrack’s company paid $540 million for the 3,399 homes ($158,000 each), buying most of them in the first six months of 2013. Now, just one year later, Colony was recouping almost all the cash it put in via JPMorgan Chase. Barrack and his investors could put that money in their pockets, use it to buy more homes, or move on to their next investment. At the same time, Colony held on to the houses and collected rent, with their tenants paying off the new mortgage-backed security.
Colony told Kroll it would be charging an average of $1,400 a month on rent, while spending just $75 per month on maintenance. Adding in its other fixed costs, including property tax, insurance, and a set-aside for future capital expenses, the ratings agency estimated Colony would clear $7,300 a year on each home in the security, or $25 million per year for the entire bundle—and that didn’t count any rent increases that Colony might levee in the future. If rents went up, they would make even more money. Kroll also assumed that one out of every ten homes in the security was vacant at any given time.4
So, what was in it for JPMorgan Chase? After all, a back of the envelope calculation indicates that at that rate, it would take thirty years for Colony to pay back its loan—a debt it had promised to retire in five. But the $514 million loan from JPMorgan Chase is just the beginning of the story of the giant ball of debt that includes the Butler family home. After providing the half billion loan to Colony, JPMorgan Chase then divided it up into five pieces—or tranches—and profitably sold those slices of debt to investors on the bond market.
These tranches were appealing, since Kroll declared they were a good bet for investors, in that they were likely to be paid back on time and with interest. Kroll gave the top tranche of the bundle—a $291 million slice of debt—an AAA grade, indicating “almost no risk.” Three of the other four tranches were deemed to be A grade—meaning that more than 80 percent of the debt was “high quality.” Other ratings agencies, including Moody’s and Morningstar, gave similarly glowing assessments of the deal.
Who were those investors—the people who would be the ultimate owners of these homes should anything go wrong? For example, who bought the top, AAA tranche for $291 million? I asked Ray Pellecchia, a spokesman for the Financial Industry Regulatory Authority (FINRA), which oversees America’s brokerage firms. “I’m not sure we know the answer to that question,” he confessed. “All transactions that take place on the bond market are reported” on FINRA’s Trade Reporting and Compliance Engine (TRACE) system, he said, but without names attached.
In any case, after their initial sale, the securities would be traded on the secondary market, where no one was keeping track. “You’re not going to get any names,” he said.
A spokeswoman for the Securities and Exchange Commission was also of no help. The government didn’t track the transactions, she said, so maybe I should check with Colony. The company might know who owned its debt.
GIANT BUNDLES OF debt owned by largely disinterested third parties leveraged against thousands of homes—that’s the twisted mess that plunged America into its worst economic downturn since the Great Depression. But we couldn’t be making exactly the same mistake again, could we? Surely America’s financial and political elite must have learned something from the housing bust. Those who forget history are doomed to repeat it, the saying goes. In this case, the crash was still visible in the rearview mirror. It seemed too early to forget.
To make sure I wasn’t jumping the gun, I called Nobel Prize–winning economist Joseph Stiglitz, the former chair of President Bill Clinton’s Council of Economic Advisers, and one of the few experts to have correctly predicted the housing bust. Sadly, Stiglitz told me that all the same problems were still in play. Because of the securitization process, the bank that lent Colony $514 million, JPMorgan Chase, had no financial stake in making sure the money was paid back. It had already sold the debt off to other investors. “It’s almost identical” to the mortgage-backed securities created before the bust, he explained, “but in one way, it’s worse,” because now the owner of the home itself is as distant as the owner of the debt. “If the owner of the home is a thousand miles away, he doesn’t know if there is a problem or not,” he said.
I told Stiglitz what I’d learned about Colony’s rental agreements—that the leases put tenants in charge of most of the maintenance—and that the data Colony shared with the bond ratings agencies showed the company spent an average of just $75 a month per home on repairs. Typically, a tenant who plans to live in a house for only a year is going to make the cheapest fixes possible, he said. “What they will do is patch it for a year.” Plus, Wall Street investors such as Colony and Blackstone weren’t in it for the long haul. They were flippers. No party in the financial transaction was looking out for the long-term interest of the houses or the communities where they were located.
“Tenants are poor,” Stiglitz said. Plus, “they move around a lot more frequently than homeowners. That’s why homeownership is efficient” from a market’s perspective. Colony’s lease agreements, he concluded, were a recipe for the properties to decay.
That wasn’t the only problem with these new mortgage-backed securities. In general, banks such as JPMorgan Chase were providing less scrutiny on the vast amounts of money they handed out to Colony and Blackstone than they were on the loans they made to individual home buyers.
When a bank helps a family buy a house, it first requires an independent appraisal. This is done to protect the bank; to make sure that the house is worth more than the amount of the mortgage. A standard appraisal form runs seven pages and includes an inspection of all aspects of the home by a trained professional, a firsthand assessment of the quality of construction, the state of the foundation, the roof, windows, staircases, heating and cooling system—anything and everything that could go wrong, down to the condition of the trim around the bathtub.5 But when big banks such as JPMorgan Chase funded mortgage-backed securities for corporate landlords, they didn’t make Colony and Blackstone hire appraisers. Instead, they relied on a cheaper tool: broker’s price opinions. BPOs don’t involve something as prosaic as having a maintenance professional check a hot-water heater. Instead, real estate brokers project a home’s value based on photographs of the house and property in combination with data on recent home sales in the area. Critics call BPOs “drive-by appraisals” and the Securities and Exchange Commission has launched an investigation into Green River Capital,6 the company that Blackstone and Colony hired7 to value the properties in their bundles. Strangely, though, the rating agencies, whose job it is to ensure that the mortgage-backed securities are worth what the banks and corporate landlords claim, were untroubled by this system. “We felt the process was diligent,” said Brian Grow, managing director at Morningstar, which, like its competitors, gave the top tranche, of $291 million, a coveted AAA rating.
From his office on the forty-eighth floor of the World Trade Center in New York, Grow argued, “There were pictures of every property.” Moreover, there was a whole system of checks to keep property values from being artificially inflated like they were during the boom. “We felt there’s an incentive for the brokers to provide accurate evaluations,” he told me. For example, each broker was tracked with a scorecard. “If it turns out that a broker is getting the value wrong, then they’ll ding that broker on the scorecard.”
But what about maintenance? I asked. How could Morningstar be confident that the properties were being adequately kept up? “One of the indicators is if there’s a tenant in the property,” one of Brian Grow’s colleagues, Brian Allen, told me. “If the property is rentable, we can make some assumption that it is in a habitable form and in good working condition.”