The latest government scheme to “cure” the ailing housing market has California communities such as San Bernardino considering the use of their power of eminent domain to seize and refinance underwater mortgages that are current on their payments.
This plan faces serious legal challenges and its implementation is fraught with problems. It is not a free lunch.
1. With billions of dollars at stake, the plan’s legality will be challenged by bond holders resulting in a multi-year legal battle. We are already 6 years into the crisis. This will only further delay the clearing of markets. The question is whether a public use (as required by law) or a private use is being served by the condemnation of these mortgages. The plan by Mortgage Resolution Partners has all losses being borne by investors. However Mortgage Resolution Partners and its investors stand to profit handsomely from this taking, raising questions about whether it is for a public use.
2. It is also bad policy. It strikes at the heart of the contractual relationship underpinning the securitization of mortgages and the relationship between lender and borrower. As with many of the actions that have been taken that are anti-investor, this will materially impact investors’ willingness to buy private mortgage backed securities and to risk the capital needed to support these securities. The result would be higher rates and the further entrenchment of the Government Mortgage Complex, which ultimately leaves the taxpayers holding the risk. This approach would be on top of other anti-investor actions. For example, private investors were not a party to the states’ attorneys general national mortgage settlement which provided for principle reduction paid from investor funds.
Since this plan would be implemented locally, investors could decide not to invest in securities from these areas, raising rates for many borrowers in the effected localities.
3. Even if found to be a legal use of eminent domain, the economic feasibility of the plan is questionable. Any taking must be based on paying fair market value – again an issue that will be litigated long and hard. The plan’s approach to determining fair market value appears to differ markedly from the likely fair value of the loans being targeted.
Of central concern is that the plan targets for condemnation the most valuable loans from an investors’ perspective – those that are making payments every month, many of which will continue paying for many years or will be paid off in full, even though they are underwater today. The plan’s economic viability is based on an assumption that each loan is worth about 85% of the current value of the home. Yet each of the targeted loans is performing today, with payments being made.
Thus, while Zillow reports that 53% of the mortgages in San Bernardino County are underwater, the serious delinquency rate in the county is 12.3%. This means about 80% of the underwater mortgages are not seriously delinquent and a sizable percentage not delinquent at all. This explains why the non-delinquent mortgages being targeted by Mortgage Resolution Partners are worth more to the investors than they propose to pay.
The plan assumes loans can be condemned at a 45% discount to current balance. A more likely fair value discount would be 25%, making the plan infeasible.
Example: Assume a paying loan with a $300,000 loan balance and a $200,000 current home value. Under the plan, investors would be paid 85% of the current home value or $170,000 – a discount to face value of $130,000 or 45%.
At an assumed default rate of 50% and a loss upon default of 50% across all condemned performing loans (a reduction in value of 25%), the average loan has a value to investors of $225,000 (112% of current home value), not $170,000 or 85% of current home value as proposed under the plan. To reach the price the plan envisions, over 85% of the loans would have to default and do so immediately.
Further, the plan appears to underestimate the high transaction costs associated with eminent domain and mortgage lending, further diminishing its viability. The loans would need to be condemned individually, likely requiring court action, and each condemned mortgage would need to be replaced with a new one. Mortgage Resolution Partners would need to be paid its expenses and profit, as would the locality. With transaction costs per loan being quite substantial, investors would also challenges efforts to pin these costs on them.
4. Finally, if value paid is not fair, this creates the potential for additional losses for those investors with the less risky slices, such as Fannie Mae and Freddie Mac. This pits one class of investor against another, adding to the expected legal battles.