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.