Bank of America Launches Test “Mortgage to Lease” Program – Should We Be Impressed?

The Wall Street Journal and New York Times have reports on a pilot program at Bank of America to allow homeowners who are likely to default a graceful exit. The Charlotte bank will allow 1000 borrowers in New York, Arizona, and Nevada to turn in the deeds to their houses in return for a one year lease with a two one year renewal options at or below market rates. The program will be only with borrowers invited by the bank, which will target homeowners who are at least two months behind on payments but can demonstrate that they can pay the rent. The Journal cites an example of a Phoenix home with a $250,000 mortgage with payments of $1600 a month. It estimates the rent as $900.

This is clearly a preferable alternative for homeowners to foreclosure. They escape the credit score damage, stress, and indignity of the foreclosure process and save moving costs. They are also spared the difficulty of finding a landlord who will accept a tenant with a tarnished payment record. It isn’t clear how the program will handle the usual rental deposit. So what’s not to like?

The devil, as always, lies in the details. Even if the program turns out to be a positive experience for borrowers and the bank, it is not clear that it is a magic bullet for the foreclosure mess. The bank is conducting the pilot on loans it owns. It appears adhere the IRS rules governing REMICs, which limit leases to two years, so the hope is that this program would be rolled out to Countrywide mortgages, which were almost always securitized.

However, it is hard to imagine that balance-sheet-stressed Bank of America would include properties that had bank-owned second liens on them, since the second would be a total loss. Borrowers with second liens have much higher default rates than those with first liens only, so many borrowers in need of help are likely not to be invited to participate.

One open question is property management. Anyone who has had a bad or lazy landlord can tell you what an awful experience it is. Banks have done a terrible job of securing and maintaining foreclosed properties. How responsive will they be when a boiler fails or the roof develops a leak or a tree falls down in a storm and damages the house?

A second question is the appetite of investors. Bank of America maintains it has plenty of demand from big investors, and the Obama administration is separately keen to promote bulk sales of foreclosed properties. I don’t see the sort of investors being bandied about, namely private equity firms or distressed investors, being good candidates. They have high return requirements and can’t manage their way out of a paper bag. And being a landlord is operationally intensive, particularly when dealing with dispersed single family homes.

Consider two cautionary tales. One is the famed purchase of Stuyvesant Town, a large complex of middle income rentals in Manhattan with a lot of rent-regulated apartments. It is still a mystery to me how this deal got done. Tishman Speyer and Blackrock made the purchase at top of market prices, and the marketing pitch assumed that they’d be able to turn a very high percentage of units into condos and sell them. But that made no sense on these apartments. Any tenant that is current in a rent regulated apartment in New York City can’t be denied a lease renewal. The housing courts have seen every bad landlord trick in the book and have little patience with them. The new owners tried harassing tenants to get them to give up their leases. When the court ruled that the investors had brought apartments illegally out of rent stabilization, the owners defaulted.

The other is the behavior of Fortress, which happens to be the name most bandied about as a prospective bulk sales buyer. But the model for Fortress appears to be the Gagfah. Some cash-strapped German cities were privatizing housing, and Fortress-controlled Gagfah bought 45,000 rental units from Dresden. Gagfah agreed to give existing tenants the right of first refusal on any sale. It was also criticized in local media for neglecting repairs. Gagfah was sued for €1 billion by Dresden and settled for €40 million.

Mind you, both of these deals were far simpler from an operating standpoint than what investors in any Bank of America sold homes will encounter Sty Town and the Dresden apartments were large, compact complexes with seasoned property management in place. By contrast, any houses acquired will be dispersed and the new buyers will have to set up or contract out the property management, and it’s unlikely that there is a turnkey solution..

And if returns flag because investors underestimated operating cost or aren’t able to flip homes when the leases expire, what do you think they will do? They are certain to neglect upkeep. They are likely to jack up rents but presumably will be constrained by supply in the area. And who will investors sell these properties to when they realize that the prices they can get in 3-4 years don’t provide their target returns? Private equity firms are not interested in being long term managers; they want to get their money out as quickly as possible.

I’m not certain the appetite for these properties lives up to the curiosity level, unless PE investors somehow have convinced themselves that the real estate market will rebound strongly on their timetable. I suspect all the hype and a few cherrypicked deals will set up dumber money, like insurance companies and public pension funds, which will go into REITs or other securitized investment vehicles. But the big issue is that these deals being done in scale and working out well depends not just on banks figuring out how to make them work to salvage borrowers, but also addressing the property management challenge.

But the real driver came at the very end of the Wall Street Journal article:

Foreclosures have slowed sharply in some states amid heavy scrutiny of allegedly forged paperwork used by processing firms. Banks completed 860,000 foreclosures last year, down from 1.1 million in 2010, according to CoreLogic Inc.

“One of the outcomes of the ‘robo-signing’ scandal is that it is more difficult to foreclose,” said Mr. [Dean] Baker. “It’s more worthwhile for banks to pursue alternatives.”

In other words, banks are so badly hoist on their own petard that they have to consider doing the right thing. But given their track record, I wouldn’t bet on them pulling it off in the way the great unwashed public hopes they will.