Quelle Surprise! Bond Investors Notice that Servicers Let Houses Fall Apart

Bloomberg last Friday, Gundlach Counting Rotting Homes Makes Subprime Bear:

The founder of $49 billion investment firm DoubleLine Capital LP is largely avoiding the subprime-mortgage bonds that jumped about 17 percent last year after home prices surged by the most since 2006, deterred by the lengthy process to sell foreclosed houses and the destruction that’s creating.

“These properties are rotting away,” Gundlach, 54, said last week on a conference call with investors, about homes stuck in foreclosure pipelines, adding that it could take six years to resolve defaulted loans made to the least creditworthy borrowers before the real-estate crash.

Needless to say, that’s a lot of spin in a short space. Notice that it’s the “lengthy foreclosure process” that is the cause of trouble, when in fact servicers delay foreclosures when they already have more foreclosed homes than they can offload (lawyers in Florida, for instance, report that judges all over the state complain that banks repeatedly postpone foreclosures). Oh, and someone in a home keeps it secure and maintains it to at least an adequate standard, while vacant homes are subject to being stripped and get in all sorts of other types of disrepair.

But the really funny bit is that Gundlach is giving his investors some sort of special insight in telling them that many of the properties backing the remaining balances in subprime bonds are falling apart.

Compare the Bloomberg story with this account by Dave Dayen in Salon last July, The Housing “Recovery” Is a Total Sham:

Out on the alphabet streets in this once-thriving Florida community, the houses are dotted with black mold. Some have buckled roofs. Others are hollowed out by fire, or the wiring has been stripped. Pests and critters have moved in as the people moved out. On some streets, half of the homes feature boards along the windows, and ubiquitous “No Trespassing: No Traspasar” signs in English and Spanish. “Those are to keep the drug sales out,” says my tour guide, Lynn Szymoniak of the nonprofit Housing Justice Foundation. “I’ve been stopped doing these tours, cops have told me, ‘you’re not supposed to be here.’”

At one time, these homes were exciting products sold by Option One, Ameriquest, New Century Financial, and other mortgage lenders who sprouted up during the housing bubble, and disappeared just as quickly….

The inflated sale prices present a serious problem for rehabilitating the community. Ninety percent of these properties are tied up in mortgage-backed trusts for large sums (“When you look them up, you’re just so amazed,” Szymoniak says), and the trustees don’t want to book the losses. So instead of selling off the old inventory, they hold onto it, hoping in vain for price appreciation or just wanting to avoid the reckoning. “If you have to keep investors thinking that you have a $300,000 property,” Szymoniak remarked, “and you want to carry it on the books for as long as you possibly can, then you don’t put it on the market, you just hold it back, and you let it go on forever.”

It should therefore come as no surprise to learn that Gundlach, who has allocated over 30% of his main fund to mortgage-backed securities, has underperformed other MBS-oriented hedge funds by a significant margin over the last three years.

This pattern is both common sense and well known to mortgage and real estate investors. Vacant properties deteriorate. And it has also been regularly written up in the business press that banks have done a terrible job of securing vacant properties, with squatting and homes being stripped of copper and appliances all too prevalent. Reader MBS Guy said that industry hands assume that a home that has been in foreclosure for three years is a close to 100% loss.

But the fact that the trusts are still carrying these loans at inflated value has had, and continues to have, important implications. Servicers keep advancing principal and interest until they come close to the mortgage balance. But if they can’t get the money advanced to investors back in a foreclosure (and the contracts call for the advanced to be repaid before any other disbursements are made), they get the funds from refinances or other payoffs (regular sales of other properties, short sales, etc), even though technically they aren’t allowed to take the money from a different property to make up for a shortfall on foreclosure (it is hardly novel to see banks taking liberties with securitization agreements). The net effect, as we’ve noted previously, is to steal principal to pay out more interest to investors. That might seem like a meaningless distinction until you understand how the tranching works. In simplified terms, as the trusts suffer default-related losses, the bottom tranches get successively wiped out. The bottom-most remaining tranche as that process continues is getting only interest payments. So if those risky tranches get more interest than they are entitled to, they are effectively stealing principal from the other tranche-holders, particularly the AAA tranches.

Who bought those risky tranches? Hedgies like Gundlach. And who holds the AAA tranches? Often, public pension funds, like ones for municipal employees.

So letting properties rot, even though Gundlach claims it’s bad news for investors, hasn’t been bad news for investors like him. Indeed, it’s one of the many mechanisms by which clever financiers profit as the expense of the less savvy. And it’s also typical for the winners to make pious noises even as the looting continues.

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  1. Clive

    Just to add a couple of nuances, one factor that US residents probably don’t even think of because it is so normal — but it does strike foreigners as being noteworthy precisely because we’re not used to it — is the incredible variability of the climatic regions in the US. This has a significant impact on the maintenance overhead of the fabric of a structure both inside and out. For instance, hot arid climates are punishing to humans but buildings tend not to be too badly affected especially if storms or high winds are rare. Obviously cold wetter climates are not good news for the built environment as water penetration is probably the biggest potential source of deterioration and, if the structure isn’t heated, will lead to burst pipes and frost damage. Storms are more likely to compromise the building structure allowing water ingress. Finally, warm and humid regions are probably the toughest because if humidity levels inside the building stay at 70%+ for an extended period anything with an organic base will eventually simply rot away. Even grouts, renders, rubber seals and silicones will succumb. Without constant energy inputs in some climates, many structures are not viable in the long term.

    A second point is the woeful standard of construction of many of the bubble-era properties. From what I’ve seen of them, they at best have an economic life of no more than 25-30 years at the most without needing major replacement of key components. I think they were designed to last only for the life of the mortgage. Pretty cynical really, but that was the mentality of the time of course. It might have worked out okay if these residences were lived in by owner-occupiers in a rising property market because they would have some incentive to make the required capital investment to stop their houses falling apart. Things didn’t quite turn out that way. Who knew ?

    To a member of the banker class, living usually in a custom build or if not a property constructed to a very high standard and maintained either by themselves or the building owner, they can’t help but fall into a trap of cognitive bias. A residence is a residence and why would they not all be like the houses they live in ? The last thing they’d think of doing is going round and kicking the tires of a Florida or Atlanta McMansion. I did and couldn’t believe what I saw.

    1. vlade

      Re your paragraph – actually, some of the hedgies did, and then went away and shorted the whole thing (including inducing banks to create more stuff for them to short).

    2. Ogier

      “A second point is the woeful standard of construction ”
      We live in a grfter culture…always have and looks like we always will. The discouraging thing is one can park in the driveway a supremely developed artifact of the industrial revolution: the automobile. Then walk into a crap built structure that is a blight on the land. Oh yeah those stainless fronted appliances really look snazzy. and the granite counters, de rigueur in any self respecting home. Unfortunately all those worthy souls that tried to market a factory made durable home all went broke.

    3. alexaisback

      I have been writing about this for 3 or more years.

      Now think for a second.

      What do you think is happening with REVERSE MORTGAGES ?

      Do you honestly believe the reverse mortgage persons are putting the money into common repairs ?

      this will be another fiasco soon enough.

  2. psychohistorian

    Thanks for a wonderfully depressing posting.

    To admit that so much of our world is on “life support” of this sort is depressing because it means that the cure, if there ever will be such, is going to be both painful and hard to execute. So many are involved in propping up the mess that it reminds me of the history I have read of the early Enlightenment period. So many want to BELIEVE that the social organization that is “western civilization” is the true faith but the facts are just not able to sustain that myth anymore.

    History will not repeat itself here as well. The world is between a rock and a hard spot and the forces of our planet bats first, last and everywhere in between. We have been inculcated to think we are gods and can overcome all obstacles. What hubris! The effluent of Fukushima in 2014 will be one of the tipping points that will refuse to be ignored. And because most of the public is in forced ignorance of what is happening the blowback will not be rational nor controllable. People losing faith in the existing social structures and in fear of the unknown will do lots of crazy things.

    So here we are at NC with the Whooocooodanoode’s on one side and those that have abdicated responsibility for their lives to the social order that is collapsing on the other. We all have our pet solutions to our problems (mine being ending wealth accumulation) but do we still believe that we can “reorganize” our way out of this mess? I am an inveterate optimist or I would not be alive and will continue to try my best to help society move forward but no longer like the odds….we are way too far down the rabbit hole and disintegrating housing stock is just another canary in the coal mine of our coming chaos.

    Peace and love to all!….especially to Yves for her pinpoint of brilliant light in our darkness.


    1. Doug Terpstra

      Very sobering insights, quite a buzzkill. It strikes me that housing bubble 2.0 and stocks bubble X.6, under five years and trillion$ of QE extend and pretend accounting, have turned the entire global market, including submerging markets, into a ginormous Ponzi op. As nature herself is foreclosing on rotting houses, she will topple the house of cards built by Wall Street and Big Oil … with a vengeance that few of us can imagine. I’m afraid j gibbs is right: war is the replacement bubble.

  3. j gibbs

    The only solutions currently being pursued are militarization and propaganda. Last night was ‘military appreciation night’ at the Thunder basketball game in Oklahoma City. Watching that Fox orchestrated performance one would think it was 1945. Ultimately, people in those red states will not know what hit them.

    And surely you know there is no reason for optimism whatsoever.

    1. tongorad

      I’m surprised at the number of retail stores I go to that ask if I am active/serving military – presumably for a military discount or what not.
      The military is without doubt the most revered institution in our society/culture. That’s going to end well, huh?

  4. washunate

    “And who holds the AAA tranches? Often, public pension funds, like ones for municipal employees.”

    I think that really gets to the heart of the matter. Our public policy choices of the past couple decades have fundamentally misallocated resources, from housing to healthcare to higher education.

    But…I think this is ultimately a hopeful situation; things coming to a head is the only way change happens. The pain is already largely baked in, and we know how to solve these kinds of problems. It’s just a matter of marshaling the political will to rebuild our society in a more sustainable manner.

    1. ambrit

      Dear washunate;
      My quibble with your optimism is that, as we have somewhat today, “Political Will” has become scattered and divided betwixt and between competing groups. Absent a concerted “grass roots” political movement, the logical outcome of all that is happening now is a return to the “Furherprinzip.” (I can hear it now: “As a result of the worsening conditions in our Nation, and the inability of the Legislative Branch of our Government to come to grips with the crisis, I am temporarily suspending the Constitution and, pursuant to the War Powers Act, assuming full powers to lead our Great Nation out of the present extraordinary situation. Thank you, and God Bless the Nation.”
      Crowd of Reporters: “Madame President! Madame President!”
      White House Spokesperson: “Official information will be released to the public every day at Noon. No questions will be taken. Please address all queries to the Office of Public Information.”
      Reporter: “Where is this Office of Public Information?”
      Spokesperson: “It’s a part of FEMA. Ask them.”
      Reporters: “Oh no! Not them again? Give us a break!”
      Spokesperson: “As per the Executive Order the President just announced, that is all I can give you. Good day.”

      1. washunate

        Yeah, I hear what you’re saying. But I think Constitutional governance has largely already been cast aside – at a strategic level, the political will is currently divided between people who want to maintain the facade and people who want to deal with the reality. I think a number of comfortable people are making the rational calculus that doing the former – keeping their heads down and looking out for their family – is the most sensible course of action at the moment.

        IMO, what is changing is that with the slow passage of time, the instability of inequality is marching up the social ladder, and housing is one of the most visible signs since the truly wealthy have no interest in middle class real estate while the lower classes have no means to participate. (Indeed, at the very bottom of our society, we have built an entirely separate housing system through prisons and Section 8 vouchers and so forth).

  5. damian

    The banks are letting the foreclosure process extend to years – now five could be ten years in the end. As the judges in places like NJ become more skeptical of the lack of cooperation in bank document discovery (train of title, etc.) – which is tactical not mistakes – the rulings are becoming increasingly against the banks where the early years experience was in favor of the banks.

    The discovery increasingly shows consistent patterns of bank practices they don’t want to turn into decisions which can be used elsewhere in other CDO’s cases individually or as a class. It is the investors they are worried about not the mortgagees.

    These are people / mortgagees / residents having their mortgages, taxes, insurance and maintenance paid for by the banks for years – which is an intelligent decision not to pay while the properties are seriously underwater. These are in many cases professional people like lawyers. While the buildings are occupied they are not being taken care of as they would be absent this charade.

    Sooner or later the banks will have to face the music and cut a deal with these people (@ 50% of 2007). It’s much worse than people think based upon the trading prices of the bonds.

    1. Eric377

      The ethics of not paying a non-recourse loan to me are pretty clearly acceptable. The ethics of not paying property taxes while owning a property are not – you are breaking trust with your fellow citizens on democratically agreed obligations, which if you have stopped paying the mortgage are very likely well within your financial capacity to handle. Intelligent or not, you should not object if people have a very low opinion of your character if you do this.

      1. damian

        “unethical”? the banks committed fraud in the virtuous system they created to defraud millions of consumers – BoA walked away on a mortgage for a branch in CA – doesn’t that set the tone ? If you sign a contract to haul the trash away to a mob controlled company that charges extortionist rates – should you continue the contract and comply with the obligations if you have an alternative?

        look everyone has an obligation to conserve their cash flow based upon the values expected – property taxes or mortgage payments are the same thing – cash – this is the USA – thugs close down bridges on a whim – banks steal everyone blind – and you want rape and pillage compliance – I don’t get it !

    2. 3184inprint

      Which NJ is this? After the Supreme Court punted in the Guillaume case in February., 2012, it has been downhill for the homeowner. Lenders/servicers still stonewall on discovery because the trial judges have made it clear that they will not enforce the discovery rules. With some judges, you have to ask permission to file a discovery motion, and permission is hardly granted. Robosigning is rampant, and summary judgment supporting certifications are little more than hearsay. I am amazed at what they get away with. Prior to the Raftogianis decision in July, 2010, it was all lender. From Raftogianis to Guillaume, a qualified borrower attorney could “win” about 50% of his or her cases. “Win” means that the lender must start over again, not that you really win. But nonetheless, “wins” led to decent settlement offers. Now, borrowers are lucky to “win” 10% of the time. Good settlement offers are down as the lenders and servicers (and their counsel) are arrogant again. In court on Friday on subprime loan in ghetto area. 340K owed on property that may be worth 150K on a good day. Lender’s attorney told me that borrower should not expect a principal reduction. Go figure. This old structure is going into a death spiral because the owner will not put any money into it. In the meanwhile, it will take over a year to go to sale, if the current lender does not flip the property to a hedge fund. If flipped, three years. House deteriorates further as does neighborhood. Vicious cycle.

  6. Crazy Horse

    As a German friend once commented, “You could drop a nuclear bomb on the majority of the housing infrastructure in the US and nothing of real value would be destroyed.” This same friend went to university in Tubingen, (Germany), founded in 1078. As a student he lived in the family student apartment where six generations of his predecessors had stayed.

    With only rare exceptions, housing in the US is designed as if the sun didn’t exist, oriented to display its facade to the neighbors rather than to capture free energy. Whether it is a starter castle for the aspiring bankster or a tract shack in Florida, the interior is invariably finished with gypsum board AKA “drywall”, a material faced on both sides with paper. The wall cavity of any such construction is an ideal growing medium for black mold, rendering a majority of such structures unhealthy for human habitation. But what the heck, isn’t that why we have a high tech medical system— to generate profits selling drugs to counteract the effects of living in a toxic environment?

    1. Clive

      Yes, spot on Crazy Horse. In Florida, as with much of the Gulf Coast, buildings should be constructed to be air tight (or as near to it as possible) and with vapour barriers wherever there is a cavity. It’s not that difficult, certainly within the techniques available to mass construction tract developers. It just costs a bit more. Ah-ha… there we go then.

      And not just for the health of the people inhabiting the resultant residential real estate. Even today, people are starting to baulk at the sorts of 100kw/day levels of energy consumption being incurred for a single family fairly modestly sized house. I’ll wager that in 10 to 20 years, this will simply prove to be unsustainable. Owners will be stuck with no choice but to retrofit better weatherproofing (or play jingle mail in non-recourse jurisdictions). Renters will have the luxury of being able to walk away easily.

    2. NotTimothyGeithner

      The house I grew up in was designed with the sun in mind. If you were in the house, one notices the lack of right angles. The house is aligned to collect winter sun, and cut out morning and evening summer sun. The architect had notes about mirror placement,and the walls aren’t straight to redirect natural light.

      Most of the nearby houses were 1920 Sears Roebucks*, and one can definitely see the cookie cutter design.

      *Houses could be ordered from magazines for over a century. My best friend lived in the model that came with a matching carriage house.

  7. Synopticist

    “Who bought those risky tranches? Hedgies like Gundlach. And who holds the AAA tranches? Often, public pension funds, like ones for municipal employees.”

    Riiiight, so that’s how it works. I often wondered what the oligarchic screw was with letting these places rot.

    1. Susan the other

      A hedge within a hedge within a hedge… like a third-rinse-laundry… laundry within a laundry within a laundry. I was ready to buy the propaganda that the PE firms had bought up most of the excess “inventory” and were dealing in RIT, or rental investment trusts – which for all purposes are exactly what MBS were. But this is not really happening. Not really appealing to rent a place with a rotting floor and roof; a broken furnace, dangerous wiring and missing copper pipes… etc. So here is a principle whose name I do not know: It is the time principle, and it goes like this: If something goes bad you should step in and repair it in a timely manner whether physical or financial repair; and extend the time required for debits and credits to equal zero, at which point all is well. If this process is preempted by good old american greed, and profiteering, then of course there is unbelievable and irreparable devastation that at some point even eats up the banksters. Umm – that sounds like a delicious banquet.

  8. kareninca

    I have seen a big and sudden change in one of the areas I watch: rural eastern CT. Whereas before in my hometown (population 5,000) there were basically no foreclosures or preforeclosures to be easily found, suddenly they are all over the Zillow site. For instance, in my hometown there are typically about 45 regular sale listings; in the winter about 36 regular sale listings. Suddenly there are 28 preforeclosures on Zillow!!!! Nearly as many as the number of regular listings!!! This is huge!!!!!

    Perhaps these preforeclosure were visible before, to people who paid for the info, or who dug. But I didn’t see them when I last looked at the free/easy sites, about six months ago. I thought that things weren’t so bad in my hometown!!! So I kind of stopped looking!!! What a moron I was.

    Zillow just shows the road the preforeclosure is on; not the street address; my parents and I by phone went over each road’s listings. It is mostly the more costly houses that are listed: the ones that were bought in 2003 for $450k, and now have a Zillow “foreclosure sale estimate” of about $250k. It may be that they are still not bothering to list the more modest houses. The costly houses would have been bought by e.g. people who worked as professionals at Pfizer and Electric Boat; they have laid off a lot of people.

    Well, it is good, sort of, that people are still occupying these houses; I hope that they have saved up some money. The houses would certainly have disintegrated without occupants. But when people start noticing these listings they will go insane. They are not up for sale yet, but the fact that they are in preforeclosure is huge. My parents were mindboggled, and they live there!!! They have plenty of friends who have lost their jobs or who are struggling, but they didn’t have any data like this (limited data) before. It wasn’t in their face like it is now.

    The more costly towns in the area still have few preforeclosures listed. The other “middle class” ones now have a zillion, like my home town. Does this mean that the more costly towns are doing better? I doubt it. I think the banks are just holding back there, for their own reasons.

  9. reslez

    “And who holds the AAA tranches? Often, public pension funds, like ones for municipal employees.”

    Ohh… so you’re saying it maybe wasn’t the brightest idea to invest retirement funds in a dirty Wall Street confidence game?

    It’s amazing to me how the media narrative is always spun as “We are helpless to enforce laws against fraud, because it would sink the market which would sink retirement funds for those helpless pensioners”. The true narrative should be: “How quickly do we tar and feather the stupid, greedy idiots who decided to do this in the first place?”

  10. Andre Mittag


    I typically love your article, but I dont like your ending here. Gundlach isn’t a ‘hedgie’ at least not when I was doing deep research on him (2011). He is a long only bond manager (meaning he didnt make much upside during the market failure, except for being in Treasuries WAAAY before everyone else). Just because someone is in Finance and making money doesnt mean they are ‘hedgies.’

    Finally, Gundlach has been relatively outspoken about much of the economic policies that have happened. In 2010 he warned against low inflation often at odds with PIMCO (Gross was walking his wealthy man line… ‘raise interest rates’ etc).

    Perhaps I haven’t done as much research as you have, but unless you have some damning evidence I am not aware of, I think you overplayed the tone.


    1. Yves Smith Post author

      Bloomberg says the Gundlach fund that invests in MBS is a hedge fund:

      Gundlach’s Hedge Fund Said to Rise 28% on Mortgage-Backed Bond Investments


      What makes a hedge fund a hedge fund, as opposed to a regular institutional fund manager, is how the fees are structured above all, and whether the fund fits into any of the buckets that fund consultants say are hedge fund strategies (such as market neutral, long-short, market driven, global macro, distressed debt, etc).

    2. Nathanael

      I think the term “hedge fund” is grossly overused.

      Anyway, Gundlach is a long-term investor. Of *course* he’s mad that the servicers are making a short-term profitable choice which is a long-term loser for him.

      The fact that different people in the finance industry have different incentives and will happily cheat each other is not news. It is, however, *useful*. People like Gundlach are tactical allies in cleaning up the sewer of “securitization”.

  11. bh2

    This is why much talk about “overhanging foreclosure inventory” in the housing market is mostly bosh. Empty houses have a finite shelf life and perish after their sell-by date.

    While the US housing market may not come roaring back nationwide, it is likely a lot of foreclosed homes will never again be marketable except as landfill.

  12. LAChased

    This is an issue that can be a reality check for all parties involved. Just as servicers use sections of the deed to legitimize doing whatever they want to sell the Note etc so can homeowners question whether the foreclosing parties have a real interest in the property such as with repairs. We have to question how it is that settlements and supposed progressive politicians point to these band aids and claim they are defending main street when the funds that are supposed to go to anti blight and anti fraud relief aren’t getting to the distressed homeowner or to the upkeep of properties. We also have to question how the right wants to again sweep everything under the rug in the name of economic freedom and liberty while they deny us our homes and the basics to live. The most frustrating part is that the “lenders” admit the harm they’ve done and the laws and settlements spell out the relief even when they have their loopholes. We Americans who are under duress need to get back to the basics and not accept everything that we’re told.

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