Not to heft blame on any particular entity for the housing collapse (well, in this article anyway), but one of the instruments that allowed the bubble to run so high in the first place was the Collateralized Debt Obligation. The CDO, as it is known, combined separate tranches (levels of security risk) of mortgages into a single security, allowing investors to pick their risk tolerance and be paid in order of defined risk. In essence, the investors in higher tranches got (and get, if you invest today) paid before the lower tranches – so if cash flows stop, CDOs become an expensive game of musical chairs.
…Which brings us to today’s clever new financial instrument. What if you took the payment ordering and splitting prowess of CDOs for home purchasers and extended it to renters? That’s right – rental CDOs! What could possibly go wrong?
Why the Need?
The reason rental CDOs are even being floated goes by a lot of names – ‘inventory overhang’, ‘shadow inventory’, etc. Basically, the idea is that a whole lot of houses that were foreclosed upon during the aftermath of the real estate bubble still haven’t been released to market. That means there are large numbers of foreclosed properties which are slowly being sold by banks and mortgage insurers (and reinsurers), which if released all at once might tank the market a second time. Enter Rental CDOs – by creating an investment which bundles rental payments into tranches paralleling its mortgage cousin, you have a brand new shiny instrument to raise money for hedge funds and investment banks to purchase homes for rentals. Here’s how it would work:
- Bank, hedge fund, large asset manager of some type owns/purchases homes
- Homes are rented out
- CDO is created with tranches based on creditworthiness/rating of renters
- Money from CDO used to buy more houses to rent
There You Go Again…
I mean, what could go wrong? Well, for starters, renters have less net worth than homeowners. Average rental leases are around a year while mortgages generally last 6-10 years. And (sorry for the stale link, help me update it) renters have worse credit scores than homeowners. The entire mess is one rating agency (ahem, 3) rubber stamp away from becoming a real mess.
As we saw a couple years ago, home prices don’t always increase. This may come as a shock to some people, such as my peers in the Bay Area, but rents can theoretically do the same thing. Just like with mortgages, if rent prices start to head south or buildings start going without renters, you’ll see entire tranches of rental CDOs miss payments. Correlation increases in a downturn!
Of course, renting and owning are the only two realistic ways to live (I know, let me hear about you living in a tent commune in the comments). The truly interesting (scary?) scenario would be a situation where home prices and rents fell together.
So, in my eyes, a rental CDO is an interesting asset class – but one of those things which might have massive repercussions 10 years down the line. I’ll probably be steering clear. How about you?
Would you be interested in investing in a rental CDO? Can you imagine a rental meltdown? Do you think these CDOs could reduce the inventory overhang?