Meet Your Hedge Fund Landlord

How subprime player Carrington Investments is milking a housing crisis it helped create.

| Fri May 18, 2012 2:02 AM EDT

Back before the housing bubble burst, sending America's economy into a tailspin, hedge fund manager and former CitiGroup banker Bruce Rose was marketing himself as the guy who single-handedly invented subprime mortgage-backed securities. Indeed, Carrington Investment Partners, part of a cluster of related companies founded by Rose, competed with the big investment banks to package and sell mortgage debt to investors. Now Rose and his companies are positioning themselves to feed off the tail end of the meltdown their business practices helped create, joining a foreclosure-to-rental trend that some experts say could hurt homeowners even more.

Earlier this year, Carrington announced a partnership with another hedge fund to buy nearly half a billion dollars worth of foreclosed single-family homes and convert them into rental properties. Carrington is by no means the only one doing this. Silicon Valley-based private equity firm GI Partners is investing more than $1 billion in similar ventures. Other foreclosure-to-rental players, according to Bloomberg, include the $19-billion investment fund Starwood Capital Group,* the billionaire media magnate Sam Zell, and Apollo Investment Management—the New York buyout firm led by the billionaire Leon Black.

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While renting out houses has typically been the province of mom-and-pop landlords, it should come as no surprise that Wall Street wants in. For years, a glut of foreclosures has suppressed home prices even as tighter lending standards and a sluggish economy have kept many buyers away. Banks, meanwhile, still sit on huge "shadow" inventories of foreclosed and abandoned properties, which means fewer places for people to live. The result of all this is a red-hot rental market—primed for speculation.

Federal regulators see the foreclosure-to-rental frenzy as a way to resuscitate the moribund housing market. In February, the Federal Housing Finance Agency announced a pilot program to sell discounted batches of Fannie Mae-owned homes to large investors in six major urban areas on the condition that the buyers lease out the properties. Advocates claim the program will give blighted properties a makeover and provide displaced homeowners with more rental options. "If you are a distressed family coming off of a foreclosure, the last thing you need is escalating rental rates," Rick Sharga, executive vice president of Carrington Mortgage Holdings, told the trade publication Housing Wire last month.

Carrington execs, noted one analyst, "appear to have managed their book for their own personal benefit in a way that screws investors."

But housing experts worry that the trend could backfire if private equity magnates amass vast tracts of rental homes only to become white-glove slumlords. "That's a big part of the concern," says Tom Deyo, the deputy director for national initiatives for NeighborWorks America, a network of 235 nonprofit community redevelopment groups. "These investments in rental homes need to be seen as investments in communities, not just as data points on some spreadsheet."

Perhaps no major player exemplifies those concerns more than Carrington, which already manages thousands of rental homes and is regularly accused of shoring up its bottom line at homeowners' expense. Although Carrington has been in business for less than a decade, it has been sued at least 100 times by borrowers, investors, and business partners.

Rose, an airline pilot and mechanic turned investment banker, launched Carrington in 2003 with $25 million in seed money from New Century Financial, a major player in underwriting subprime loans. During the heady days of the boom, Carrington's value swelled to more than $1 billion as New Century supplied mortgages that Carrington then packaged and resold as bonds at various grades of risk—"such an intimate tie between a lender and a hedge fund is highly unusual," BusinessWeek later noted

Carrington held the riskiest (and highest-yielding) bonds for itself, which meant it was first in line to take a hit in the event of defaults. In 2007, as the subprime market imploded, New Century went bankrupt. But rather than going down with the ship, Carrington raised $188 million to purchase its partner's infrastructure and mortgage-servicing business. According to a lawsuit filed by a company that managed foreclosed homes for Carrington, the hedge fund avoided booking losses on its high-risk bets by delaying the sale of the homes—a strategy that hurt the management company and holders of Carrington's less-risky bonds, who would have recouped at least some of their cash when the houses sold.

Carrington charged  exorbitant fees, pushed unconscionable home loan modifications,  and claimed it had modified loans when it hadn't, an Ohio suit alleged.

Rose even refused to return $1 million to a hedge fund investor who wanted to exercise his contractual right to get his money back, according to one lawsuit. Amherst Securities analyst Laurie Goodman summed up Carrington's approach for American Banker: "They appear to have managed their book for their own personal benefit in a way that screws investors."

In 2008, after being sued over New Century's mortgage practices in Ohio, Carrington signed an agreement with the state's attorney general to engage in "good faith" loan modifications with eligible borrowers. A year later, though, the AG took Carrington back to court, alleging that it had violated the agreement by ignoring borrowers' requests for assistance, misrepresenting its ability to help them, charging them exorbitant fees, pushing loan modifications that were "unconscionably" favorable to itself, and claiming that it had modified loans when it hadn't. Without admitting fault, Carrington settled that case last year.

To date, however, Carrington has faced dozens of suits from homeowners accusing the company of fraudulent or negligent lending practices. In an ongoing case filed against Carrington last year, John Thornton of Bonner County, Idaho, has accused the company of slapping him with $1,400 in unexplained fees and forcing him to accept an abusive loan modification. According to the suit, Carrington told Bonner that if he made the payments on his mortgage, he would be deemed to have accepted the modification he didn't want. But if he didn't, Carrington could foreclose on his home.

In another case, Los Angeles Homeowner Eladio Guerra accused Carrington of duping him into signing a predatory loan and then misleading him about getting a loan modification so that it could collect more fees before foreclosing on him. The suit (which was ultimately dismissed at the plaintiff's request) claimed that Carrington and its partners had a motive in taking the Guerras' home: The companies "have substantially more money than the average homeowner and are in a better position to maintain and rent out the property until equity values in the marketplace rise." In other words, Carrington would make more money as a landlord.

"If the ownership rates in neighborhoods go down," says one expert, "so will property values."

"For the record," Carrington's Rick Sharga notes in an email response to questions from Mother Jones, "our company has never set out to purposefully shortchange homeowners, and in fact has one of the best track records in the industry in terms of successful loan modifications...Foreclosure, from our perspective, is always the last alternative, but is sometimes, unfortunately, unavoidable." He included Carrington's response to American Banker, in which a lawyer for the company defends its business practices.

While injecting new rentals into a hot market might lower rents in the short term, some observers worry that the rise of hedge fund landlords could end up making housing less affordable. "As properties concentrate in fewer and fewer hands, there is a theory that that has the effect of driving up rents," says Matthew Desmond, an assistant professor in Harvard University's sociology department. In a 2010 Chicago Tribune op-ed, Desmond fretted about the Walmartization of the rental market. Unlike the homeowner who buys a second property to generate a little income, he says, mega-landlords can raise rents by cornering the market and setting prices using advanced speculating technologies.

What's more, in home-sales markets that have hit bottom, big players like Carrington might bid prices beyond the reach of low-income buyers, denying locals the chance to benefit from post-crash appreciation. Lower rates of home ownership can have negative affects on a community, too: According to a study published in the journal Housing Policy Debate, for instance, homeowners typically report higher self-esteem and happiness than renters. A study of homeowners in the New York City suburbs found that they were less likely than demographically similar renters to be crime victims.

Turning too many homes into rentals might even put a drag on the housing recovery. Numerous studies show that homeowners do more than renters to maintain and improve their properties and participate in neighborhood civic groups. The bottom line, says William Rohe, director of the Center for Urban and Regional Studies at the University of North Carolina at Chapel Hill, is that "if the ownership rates in neighborhoods go down, so will property values."

Some insiders have questioned whether Carrington's plan to rent out foreclosed homes is just another way to conceal its bad subprime bets. "Our feeling was that letting things pile up in [foreclosure] and then trying to rent out foreclosed homes was largely just forestalling the inevitable, and they were doing it because they owned [the riskiest] portions of the capital structure," an anonymous Carrington investor told American Banker.

But now that the stars of the rental and foreclosure industries have aligned, Carrington could end up in a better economic position than when it started. It has grown from a mere hedge fund into what its website describes as a "vertically integrated operating business that direct[s] every aspect of the life cycle of single-family assets," with its own real estate brokerage, mortgage origination and servicing firms, property management company, building restoration contractor, and marketing outfit. Converting foreclosures to rentals "is one of the best ideas to come along relative to the housing market in a long time," Sharga told industry website MortgageOrb last month.

At any rate, it seems like a good bet for Carrington.

Correction: The original version of this article stated that Starwood Capital Group owns the Westin hotel chain. Starwood divested from the chain in 2000.