Rent Backed Bonds and Idiotic Humans
The world around us is chaotic and destructive.
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This is a good thing.
Today’s post is a follow up from last week – if you haven’t read that article, you can read it here.
When nature gets beaten up, it doesn’t wither and die. It doesn’t tuck it’s tail. No, it comes back stronger.
Animals die, species die, but the whole endures and becomes resistant to the events of the past. Human progress is the same beast. Ideas, methods, and people get dislodged destroyed to make way for the new, but always as a march towards improving our lot in life. It’s this ability to get whooped and come back stronger that Nassim Nicholas Taleb coins Antifragility and explores in his book “Antifragility: Things that Gain from Disorder.”
Consistent stress is natural and healthy. The trouble is humans can’t handle the pressure. We’re terrified of the uncertainty…as we should be. It’s all well and good to tell a group of antelopes they’ll be stronger in the long run if the lion eats a few of them, but that doesn’t make the feline’s dinner feel any better.
Fear drives us to idiocy. Whenever we can we attempt to mask the natural ups and down to make us feel safe. This doesn’t work. The chaos is still there, building sufficient pressure to burst through our safety measures. All our efforts to create a false sense of security end up making the inevitable chaos far more debilitating than it otherwise would have been.
Specific topics are explored in more detail in part one of this article, but now the time has come to bring it back to real estate. In today’s installment, I’m going to explore a frightening trend. Us human folks are at it again, taking a jittery and uncertain atmosphere and attempting to smooth it over so we can feel safe.
Rent Backed Bonds
First, a quick history lesson. Here is a rough course of events that led to the 2003-2007 real estate bubble and the 2007/2008 correction. This is overly simplified.
- For time immemorial, banks made loans to people to buy homes. If the buyer didn’t make good, the bank was on the hook.
- Then one day the government decided it was really important to encourage banks to lend aggressively. So, they created some organizations to buy the loans (FNMA and FHLMC were the main two). This made the banks more money since they now could loan to otherwise non creditworthy individuals and offset the risk to the government.
- Still the banks weren't happy, so they took matters into their own hands. They starting creating new "instruments" backed by the mortgage payments. The theory went that even though an individual loan might be risky, if you get enough together, it becomes safer. The ultimate recourse for these instruments was the underlying real estate.
- These new instruments received AAA ratings, and sold like hot cakes.
- Banks made a lot of money and decided they wanted to make more money.
- The "safety" and profitability of these instruments encouraged more and more to be made. Eventually the banks just wanted any loan they could get their hands on, because they knew they could package it and get it off their books.
- Eventually enough poor loans were made that it sideswiped the entire industry.
Now let’s look at what’s happening today.
- For time immemorial, landlords rented properties to tenants. If the resident didn’t make good, the landlord was on the hook.
- Then one day the government decided it was really important to encourage landlords to rent aggressively. So they created some organizations to pay rent for those who couldn’t afford it (Section 8). This made the landlords more money since they now could rent to otherwise non creditworthy individuals and offset the risk to the government.
- Still the landlords weren’t happy, so they took matters into their own hands. They started creating new “instruments” backed by the rent from tenants. The theory was that even though an individual tenant might be risky, if you get enough together it becomes safer. The ultimate recourse for these instruments was the underlying real estate.
- These new instruments received AAA ratings.
Don’t Panic Yet
We’re now seeing the first of the institutional investors hitting the market with these rent backed bonds. As of today, the only way to issue one of these instrument is to own the real estate, which carries with it a host of problems (lack of liquidity, high transaction costs, low margin, etc).
However, more institutional players are rushing into the game. In the last year, three new REIT’s IPO’d with a total market capitalization of 3 Billion. That’s very small.
Prior to December of 2012, there was not one single family REIT. This is a clear emerging trend in the market (and one I hope to capitalize on).
The trouble is as more institutional players jump into the market, we could see a flurry of rent backed securities. My prediction:
- Institutional investor rents property
- Investor sells proceeds from rent onto third party (possible Blackstone as they’ll have experience in the game)
- Investor gets high percentage of future potential rent proceeds today, and use these funds to buy more property
- Blackstone bundles a large number of these “rent promises” and issues a “safe” new instrument
Once we start seeing these third party instruments crop up, accountability will become a distant memory. The person selling the new products won’t care if they perform in the long run. He makes his quick buck and if anything goes wrong, the buyer’s only recourse is against the tenant.
Electronic market places to sell your leases will crop up (called secondary markets) and anyone with a rental property…not just institutional investors…will be able to sell their tenant debt.
This trend will run its course for a while until a sufficiently large disruption happens and the whole thing collapses.
Wrap It Up: We Do Silly Things
Humans like to make things nice and smooth and easy. We’re optimistic to a fault. When we start creating systems designed around this poor assumption, we get ourselves into trouble. It might look like gravy for a while, but when things turn bad, they get real bad.
The recent housing bubble and subsequent correction is a great example.
The terrifying thing is we’re laying the groundwork to do it all over again.
What can we do today? Not much other than wait and see…and hope we don’t caught up in irrational exuberance again.
Photo: sara biljana