Lewie Ranieri wants to fix the mortgage mess
The legendary financier behind mortgage-backed securities is trying to repair the damage - and make a bundle in the process.
(Fortune Magazine) -- Lounging in his giant conference room in an otherwise bland office suite near Long Island's Nassau Coliseum, Lewis Ranieri cultivates the image of a worldly philosopher. The 62-year-old financier prides himself on being a big thinker who conjures elegant solutions to epic problems.
And the evidence of his searching intellect is spread all over this room, which doubles as a sort of museum for his collection of precious relics. Framed mid-19th-century letters from poets Robert Browning and Alfred, Lord Tennyson, hang on the walls, three Remington statues rest on pedestals, and a marble bust of Benjamin Franklin sits in the corner.
But the most space by far is devoted to the figure Ranieri calls his greatest hero -- Abraham Lincoln. On display are a dozen items of rare Lincoln memorabilia, including a bronze likeness of the Great Emancipator, his handwritten letter naming Gen. Ulysses S. Grant as the commander of the Union army, and even a debt-collection notice to Lincoln from a Charleston cotton merchant.
Okay, it's a stretch to connect the earthy Brooklyn-born private equity investor and powerboat enthusiast to the giant who freed the slaves. Still, Ranieri clearly draws inspiration from his idol. And in his own way he's trying to do his patriotic duty. The problem that Ranieri is now addressing is the No. 1 roadblock to America's economic recovery: the mortgage crisis.
To solve it, Ranieri is combining what he describes as a Lincolnesque dedication to helping the little guy with a technical expertise honed handling home loans "since the beginning of the world."
"Lincoln spent nights concocting ways to pardon soldiers and perform good deeds for widows," intones Ranieri, clad this day in pink shirt and chinos, with a BlackBerry holstered to his hip. "I'm willing to do what the banks and government won't -- the manual labor to help struggling homeowners. It's cathartic for me."
Many readers, especially younger ones, may not remember Ranieri. Put simply, "Lewie" (as he has long been known to friends and colleagues) was arguably the most important figure in the creation of the modern mortgage industry that he now seeks to repair.
At Salomon Brothers in the 1980s, Ranieri virtually invented mortgage-backed securities, the innovation that more than any other led to the explosive growth in homeownership by expanding the pool of money available for lending to buyers. As the head of the mortgage desk, Ranieri assembled a storied band of overweight, uncouth traders whose exploits were immortalized in Michael Lewis's book "Liar's Poker."
Since his Salomon days, Ranieri has largely shunned the limelight while pursuing a variety of ventures in the mortgage business. At least until recently, when America's real-estate-based prosperity crumbled and he went from being venerated as a legendary pioneer to being vilified for fathering the multitrillion-dollar market that went stark raving mad and sank the economy along with it.
Now Ranieri is championing an inventive solution for fixing the mess he's accused of enabling in the first place. Ranieri has raised $825 million from 31 foundations and corporate and public pension funds, including the South Carolina Retirement Systems, to form the Selene Residential Mortgage Opportunity Fund.
Selene's mission is simple: to buy delinquent mortgages at a deep discount, work with homeowners to get them paying again, and resell the now stable loans for profit. To get homeowners to do their part, Ranieri is taking the radical step of substantially lowering their mortgage balances.
For the Rodriguez family of Chicago, for example, that meant cutting the value of their loan by $160,000. To Ranieri, this willingness to slash the loan balance itself rather than just temporarily lower interest payments is the Big Idea, the essential solution the banks and government are missing. He sees his approach as a model for stemming the tide of foreclosures that is plaguing the housing market.
It's not just theory. Ranieri is also doing the "manual labor," enlisting a handpicked team of workout specialists who bill themselves as "servicers with a soul" and behave more like sunny salespeople than bill collectors.
The members of his team act as credit counselors, advising spendthrift borrowers to sell a second car or to change the weekly dinners at Outback Steakhouse to monthly. Selene will even pay off their credit card balances or fix the garage if it helps them pay the mortgage and keep their house.
Ranieri claims that part of his motive for forming Selene is to atone for launching the securitization juggernaut that spun out of control. "I do feel guilty," he confesses. "I wasn't out to invent the biggest floating craps game of all time, but that's what happened."
It wasn't the concept of securitization that created the problem, argues Ranieri. Rather, he blames Wall Street for blatantly misusing his brainchild to construct an immense bazaar for "affordability products" that homeowners really couldn't afford, including loans with low so-called teaser rates that became onerous when they reset.
"This isn't checkers," he says. "These are real people losing their homes. I feel a responsibility for dealing with it in a way that's up close and personal."
The venture isn't all log-cabin idealism, of course. Ranieri loves a buck, and he's found a vehicle to generate strong returns for himself and his investors. He also doesn't harbor any illusions that his relatively small fund alone can make an impact on the vast U.S. real estate market. But what counts is the effectiveness of his formula, and whether that formula could prove a template for America's lenders to forestall the dangerous wave in foreclosures. Right now, Ranieri's method appears to be working. In fact, it could be the best solution yet for keeping millions of strapped homeowners in their houses.
Why is Ranieri's approach so promising? The answer is that it addresses head-on both of the major reasons why millions of Americans are defaulting on their home loans. The first is that they simply can't afford the payments, generally because the family borrowed too much and then suffered a big loss of income in today's withering recession.
But that's only half the story. The second reason for the surge in defaults is that a large and fast-growing slice of America's homeowners are stuck with "upside down" mortgages that are far higher than the value of their homes.
What makes this housing crisis so different from past shocks is the enormous price declines that pushed down the value of houses by as much as 40% and 50% in bubble markets from Florida to Nevada to California. Those staggering drops have left about one mortgage in four "underwater," according to First American CoreLogic. In Nevada, Florida, and Arizona, the average underwater house is worth 30% to 40% less than the mortgage balance. Faced with such long odds against ever breaking even on their investment, many homeowners simply walk away.
That phenomenon is adding immensely to the historic scope of the foreclosure problem. Today an astounding 4.2 million home loans -- one out of every 12 in America -- are either delinquent or in the process of foreclosure, according to Moody's Economy.com. That's three times the total from three years ago, and the highest number since comparable data became widely available starting in 1979.
Most loan modification programs don't address this issue of negative equity. As a result, they fail to keep people in their houses for more than a few months. The programs -- including those for most large banks, and for loans guaranteed by Fannie Mae (FNM, Fortune 500) or Freddie Mac (FRE, Fortune 500) or owned by the FDIC -- typically lower interest rates for a few years so that homeowners can afford the payments temporarily.
But the default rates on these modifications are now averaging around 50% after six to nine months, demonstrating that the one-track approach of lowering payments isn't a durable solution.
"The redefaults on loans that are modified without lowering principal will just keep growing," says Edward Pinto, chief credit officer with Fannie Mae in the late '80s and now an industry consultant. "The only way to slow foreclosures is to tackle the negative-equity issue."
Ranieri believes, with good reason, that borrowers will keep paying only if their restructured mortgages both are affordable and give the borrower a new equity cushion. "Positive equity is the most important factor in getting people to pay again," says Ranieri. "If they're far upside down, they think their house will never be worth more than their mortgage, so they act like renters. They're not about to enrich the bank by fixing the boiler."
The tonic of positive equity plus Selene's personal touch produces remarkable results. According to Ranieri, just 7% of Selene's restructured loans redefault by the six-month mark, a crucial yardstick to determine if they'll keep paying. So far Selene has invested about half its $825 million war chest, and Fortune estimates that it is delivering a consistent return of between 10% and 12% -- good numbers in a world where 10-year Treasuries yield 3.4%.
Small wonder that other investors are jumping into the game. Hedge fund Fortress Investment Group (FIG) and famed distressed-assets buyer Wilbur Ross are among those on Wall Street who have recently begun buying mortgages cheap and writing down principal.
"If you give them equity, borrowers will start paying again and defend their houses, not damage them," says CEO Jeff Kaplan of National Asset Direct, a company whose affiliates have so far acquired more than $200 million in delinquent home loans.
Wall Street has seldom seen a more unlikely success story than Lewie Ranieri's, or one more full of Rabelaisian excess. Ranieri grew up in a three-story building in Brooklyn; his grandfather's bakery occupied the street level, and Ranieri, his brother, and seven cousins squeezed into the top-floor apartment.
After his father, a Navy scientist, died from handling toxic chemicals, Ranieri went to work at his uncle's Italian restaurant in Great Neck, Long Island. The commute was so long that Ranieri, at age 15, enrolled in the Great Neck high school. Ranieri cooked lasagna and gnocchi until the early morning hours, then rushed home to an apartment he shared with his co-chefs from Italy and Argentina, returning to Brooklyn, and his mother, only on weekends.
At age 18, Ranieri dropped out of college to work full-time in the Salomon Bros. mailroom. Over time Ranieri rose from designing computer systems to pioneering "securitization," a term he actually coined.
He not only ran Salomon's biggest money-making unit but also brought his own zany style to Wall Street. Ranieri and his team famously devoured onion cheeseburgers for breakfast. For a laugh, the boss would set traders' pants aflame, Bic lighter in one hand, fat cigar in the other.
In 1987, Salomon CEO John Gutfreund fired Ranieri for loudly challenging his decisions and demanding far bigger pay for his team. Since then, Ranieri has worked on his own terms.
He stepped in as chairman of Computer Associates after a notorious accounting scandal, helping the software maker restore its business and reputation. He also runs Hyperion Partners, a private equity firm that invests primarily in software startups and mortgage companies. (Hyperion was one of the Titan gods of ancient Greece; Ranieri later named his mortgage fund after Hyperion's daughter, Selene, a moon goddess.)
His successes include Bank United, a Houston thrift he rescued in the late 1980s, then sold for $1.5 billion in 2001. Ranieri, however, stumbled badly on his next foray into mortgage lending with Franklin Bank, a Texas lender where he served as chairman.
Franklin went bankrupt last year, chiefly because of its heavy exposure to residential developers during the bubble --a surprising misstep given Ranieri's real estate pedigree. (Ranieri says he can't comment because of pending litigation.)
All told, Fortune estimates Ranieri's fortune from his profits on Bank United and investments in private companies in the low hundreds of millions of dollars.
Ranieri developed his blueprint for fixing mortgages for profit two decades ago, when a housing hurricane struck Houston. His vehicle was the stricken thrift he later sold for a big profit, Bank United.
When Ranieri arrived in 1988, the entire Houston market, ravaged by a collapse in oil prices and jobs, resembled the hardest-hit areas of the U.S. today, with thousands of mortgages underwater by 30% to 40%. "It was so bad that people sent in envelopes with their keys," Ranieri recalls. "We called it 'jingle mail.'"
Ranieri took a totally different tack from his competitors. He lowered principal payments to make them affordable, and most of all, to restore homeowner equity and pride in ownership.
Once their loans were modified, the upright Texans paid right on time, with few new defaults. "It was a dress rehearsal for what we're seeing now," says Scott Shay, a Ranieri partner who started with him at Bank United.
When the subprime implosion began in late 2006, Ranieri seized on the idea of replicating his workout model, and his success, from the old days in Houston. To do it, he needed to re-create what he'd built at Bank United, a "special servicer" that could work one-on-one with borrowers, whose staff served as credit counselors instead of debt collectors.
The problem was that mortgage markets were so good, for so long, that personalized servicing barely existed anymore. Most servicers are giant, highly automated operations that mail out statements, process checks, and make escrow payments.
The four biggest banks -- Bank of America (BAC, Fortune 500), J.P. Morgan (JPM, Fortune 500), Citigroup (C, Fortune 500), and Wells Fargo (WFC, Fortune 500) -- control two-thirds of all servicing. When things go bad, they tend to foreclose and move on as quickly as possible.
Ranieri called on old friends who'd been nurturing special servicing during the good times. Dave Creamer, 62, and Charlie Dunleavy, 66, had retired after building and running a $300 billion servicing portfolio, chiefly for office and other commercial buildings, at GMAC.
After getting the call from Ranieri, they recruited Karen Bellezza, 53, their deputy from GMAC. Ranieri then dispatched the three of them to find a servicing operation they could mold into a powerful unit for rehabbing residential loans.
Ironically, the quest took Ranieri back to where he first learned the trade, Houston. In late 2007, Ranieri's team bought the servicing arm of a bankrupt lender named Aegis Mortgage from private equity firm Cerberus for a mere $500,000.
The plan wouldn't work, however, without a major change in the tax code. The IRS treated reductions in mortgage principal the same as income. Hence, if Ranieri lowered balances to keep people in their homes, they'd get killed at tax time. "If someone can't pay their mortgage," says Ranieri, "how are they going to pay a big tax bill?"
But Ranieri had developed strong lobbying skills and Washington contacts over the years, starting with his successful campaign in the 1980s to change the tax laws to open the mortgage-backed securities market.
So in 2007, Ranieri, along with other mortgage executives, lobbied the Department of the Treasury and congressmen, including Charles Rangel of New York, to change the law. "I've never seen a bill move that fast on Capitol Hill," says Shay. Rangel introduced the bill in late September, and it was law by December.
How can Selene absorb those big principal write-downs and still make money? Put simply, the fund's expertise at buying stricken portfolios on the cheap leaves lots of room for reducing balances and paying the servicing personnel, and still preserves a good margin for investors.
To determine how much to pay, the Ranieri team employs a combination of scientific forecasting models and psychological profiling. It uses two types of models.
The first model -- a proprietary system devised by a team of Ph.D.s at a cost of several million dollars -- charts the future course of home prices. It incorporates data from 7,000 zip codes across the country on employment trends down to local factory closings, the relative cost of owning vs. renting, and the income required to carry a home at current prices compared with the historical averages.
The conclusion? Selene reckons that prices have around 10% further to fall nationwide, and even more in areas like the Northeast which have so far escaped the worst of the damage. Hence, Selene would demand a bigger discount for a portfolio of loans in, say, the New Jersey suburbs.
The second model examines the profiles of the borrowers behind the battered portfolios. Selene has developed a matrix of around 10 characteristics to assess the probability that it can get a mortgage paying again. Says Dave Reedy, who purchases the packages for Selene: "The two most important factors are, first, do they have a job so they can pay? And second, how badly do they want to stay in the house?"
Selene shines at weighing the borrowers feelings and attachment toward their homes. The Selene team carefully reviews the notes from the calls to the homeowner from the previous servicer. The amount of contact is crucial. If the borrower has phoned frequently to request a modification, or even to complain about not getting one, the chances are far better that Selene can rehabilitate the loan.
If the old servicer hasn't talked to the borrower in 12 months, he's probably headed to foreclosure. Another key measure is the number of years the family has lived there.
"If they've been in the home a long time, they often don't want to move and pull their kids out of school," says Reedy, adding that Selene will pay far more for loans with an average occupancy of five years than it will for those that are two years in.
Selene also highly favors a portfolio where the average borrower has paid fairly recently -- say, within three months. Unlike fine wines, delinquent loans do not age well.
What is the typical profile for the Selene's delinquent borrowers? "They are mostly people who had no margin of incomes over expenses because of the size of their mortgages," says Bellezza. As a result, medical expenses for a new baby, a leak in the roof, or any other unforeseen expense would wreck their fragile finances.
After running the numbers, Selene buys most of the portfolios for between 40% and 50% of the face value of the loans -- in other words, the balance the borrowers still owe when Selene purchases the mortgages. That steep discount gives Ranieri the latitude to reduce principal. Selene structures the new loans so that they meet FHA guidelines for down payment and affordability.
Then, Selene holds the mortgage on its own books for at least six months. If the borrower makes all the payments on time for that period, the loan frequently qualifies for an FHA guarantee. At that point, a big bank or another FHA-qualified lender will refinance the mortgage at the new lower balance, and give the proceeds to Selene, which generally books much more from the refi than it paid for the loan.
If you're worried about the FHA guaranteeing all these mortgages, you're not alone. Ranieri expects the default rate on the loans that Selene repackages to remain relatively low. But the same can't be said for the vast majority of loans currently being guaranteed by the FHA, including the ones it's now modifying itself. And Pinto and other experts believe that the agency's insurance will be insufficient to cover the losses.
Once Selene has purchased a batch of loans, its servicing staff takes over. The first challenge is getting the often browbeaten borrowers on the phone, no small task considering the trauma from the harassment they have probably endured.
Instead of the usual threatening calls, Selene sends out a letter on thick stock paper that looks like a wedding invitation with the heading, "Get to know your new mortgage company." For particularly elusive borrowers, it dispatches process servers who hand them a document with a specific number that's designed to get their attention. (For example: "We can lower your mortgage balance by $50,000!")
Once the servicer reaches the borrower, the real work begins. He collects a breakdown of all the borrower's major expenses, including credit card and car payments, and costs of day care, cellphone, Internet, and health insurance. He then adds in a "cushion" of around 10% of their gross income for emergencies; for a family making $60,000 a year, about the Selene average, that's $500 a month.
The servicer then subtracts those expenses and the reserve -- excluding mortgage and other housing costs -- from income. What's left is the amount the family can afford for mortgage, property taxes, and insurance.
Consider how Jane and Gerardo Rodriguez of Chicago -- the couple that got $160,000 lopped off their loan -- benefited from Selene's loan restructuring process. One refi after another had saddled the family with a $4,052-per-month housing payment, putting their budget on the brink. Then Jane lost $600 a week in income when the recession killed her day-care business. Even on Gerardo's $90,000 salary as a truck driver for a beer company, the family couldn't come close to supporting their 10 children, including three in college.
"The old mortgage company was calling at 10 at night, threatening to take our house," says Jane. "I wanted to blow up the phone. I'd cry all the time. It was a nightmare."
By applying its formula and lowering their balance from $420,000 to $260,000, Selene was able to cut their monthly payment by half, to $2,052. "Now we can pay the mortgage without getting the lights shut off," she says. The reduction also gave the family positive equity.
What if a family just can't afford to pay, perhaps because the breadwinner has lost his or her job? Even in that scenario Selene has found a way to drastically decrease the rate of foreclosures by enticing borrowers to cooperate in a "short sale."
In a short sale, the lender typically agrees to cooperate with the owner in selling the house and to take the proceeds knowing that it will be less than the full value of the mortgage.
Selene adds a carrot: It typically pays the owner $5,000 to cover moving expenses and a couple of months' rent if they stay in the house, mow the lawn, and make nice with the real estate agent -- basically doing everything short of baking cookies to make a sale go smoothly. Selene finds that by keeping the house occupied and attractive, it's able to garner a premium of 20% over what neglected homes sell for in foreclosure.
Back in the conference room, Ranieri exudes a reflective calm that is at odds with the legend of the portly prankster. His life now, he says, is quiet and contemplative. After his wife of 30 years, Peg, died of cancer two years ago, he "moped around for a few months," then threw himself into a work schedule that leaves no time even for his once-cherished boating. "They used to say I had more powerboats than suits," he reflects. "Now it's the opposite."
He recently lost 85 pounds, to weigh in at an adult record of 225. "I've found the secret to losing weight: Don't eat!" jokes Ranieri, a longtime gourmand who says he now often dines at home on yogurt and an apple. His highly spiritual reading list includes a biography of Saint Paul called "Great Lion of God."
And with Selene, he's trying to burnish his legacy by rescuing the real estate market one mortgage at a time. A line from Lord Tennyson's handwritten letter on the wall reads, "He makes no friend who has never made a foe." Ranieri, the designer of a world gone wild, is making a lot more friends than foes fixing the damage.