U.S. Markets closed

REIT must-know: Why the REO-to-rental trade was born

Brent Nyitray, CFA, MBA

Must-know: Mortgage reform and the future of housing finance (Part 1 of 5)

The Federal Housing Finance Agency

The Federal Housing Finance Agency (also knows as FHFA) is the government entity charged with handling the GSEs (government-sponsored entities), Fannie Mae and Freddie Mac. Once these two companies collapsed in 2008, the government took over and placed them in conservatorship. This meant that FHFA has the authority of the board. Immediately after the bust, Ed DeMarco was put in charge of FHFA as the acting director. The main part of that job was to ensure the GSEs continued in their mission to provide mortgage capital in the context of minimizing costs to the taxpayer. Post-crisis, the private-label securitization market was nonexistent. If a loan didn’t fit in the conforming box, it was unsecuritizable, and any originator who did one was stuck holding it on their balance sheet. Even today, the U.S. taxpayer backs roughly half of all mortgages outstanding and 90% of new originations.

The birth of the REO-to-rental trade

Ed DeMarco was subjected to a lot of criticism from the left over the issue of principal forgiveness on Fannie and Freddie loans. Fannie Mae and Freddie Mac had huge balance sheets of loans that they chose not to securitize and intended to carry. Many of these loans were Alt-A and subprime loans. While Fannie Mae securities weren’t filled with subprime loans, Fannie Mae’s balance sheet was. And when the real estate bubble burst, Fannie Mae was stuck with a bunch of non-performing mortgages backed by collateral that was depreciating like sushi. Fannie Mae chose to sell a lot of these non-performing loans to professional investors like Blackstone (BX). The government stipulated that the buyer must hold these loans for two to three years before dumping them or the collateral. This was the genesis of the REO-to-rental trade, where hedge funds bought distressed properties for rentals. REO stands for “real-estate-owned,” or foreclosed, homes. The intent of this policy was to support home prices, which are a critical input into the returns of non-agency REITs like Two Harbors (TWO), Redwood Trust (RWT), PennyMac (PMT), and Newcastle Investment (NCT).

Continue to Part 2

Browse this series on Market Realist: