The Nuclear Option

Before I ramble, I want to give a quick shout out to Burt Likko for some information and clarifications on a couple of the legal aspects discussed within this post.

Background

The use of eminent domain as a means to seize underwater mortgages that are collateral in private-label mortgage-backed securities, typically those packaged and sold by the Wall Street banks during the housing bubble, is back in the news.  It made a splash in certain parts of the real estate and finance industry in 2012 when a private advisory firm named Mortgage Resolution Partners (“MRP”) pitched the idea to several communities, including San Bernardino County, CA, Brockton, MA and a few others (MRP’s pitch materials here along with a FAQ here). 

Per the company website:

Mortgage Resolution Partners (MRP) is a Community Advisory firm working to stabilize local housing markets and economies by keeping as many homeowners with underwater mortgages in their homes as possible.

America is experiencing an historic national mortgage crisis. Due to a collapse of home values, one in five mortgaged homeowners owe more than their homes are worth; more than eleven million families are now underwater. Nearly three million of these families are in default and on their way to foreclosures that will depress home prices further, causing still more foreclosures. MRP seeks to stem this tide.  (Click here to see the severity of underwater mortgages in the U.S.) 

More:

• Assists communities in using their power of eminent domain to acquire underwater mortgage loans and offering to refinance them into sustainable loans with lower principal balances.
• Prevents the costs to communities and neighbors of future defaults and foreclosures. 
• Is voluntary; does not affect homeowners who choose not to refinance.
• Is privately funded, requires no taxes or funding from communities or homeowners. 
• Targets loans trapped in private securitization trusts; avoids mortgages whose owners have broad powers to reduce principal, such as banks and government agencies. 
• Creates incentives for homeowners to maintain their good credit to qualify for the program.  Many other mortgage programs require borrowers to default before considering their needs.
• Is designed and controlled by each local government, which chooses the loans and methods for resolving them to meet local needs.  Local governments may include other types of loans, including delinquent and defaulted ones, and other types of resolutions, including leasebacks to homeowners who do not qualify for a refinancing and facilitating voluntary short sales for homeowners frustrated by multiple lienholders.

At the time of this writing, MRP is still seeking municipalities that have an interest in moving forward with a proposed plan.  Several communities that have considered the idea have since walked away.  The idea remains as untested as it does unprecedented.

Intellectual arguments for using eminent domain in this fashion were developed shortly after the 2008 financial crisis, and the most notable person making the case for it is Robert C. Hockett, a law professor at Cornell University.  His arguments are available as a white paper and an article titled “Paying Paul and Robbing No One: An Eminent Domain Solution for Underwater Mortgage Debt” (via Barry Ritholtz).  From these sources, I understand Hockett’s assumptions as follows:

(1)  Because housing prices will not revert to to pre-crisis levels, currently underwater mortgages, especially mortgages deep underwater will remain that way.

(2) Therefore, some kind of loss is inevitable

(3) Negative equity is associated with higher levels of default and foreclosure risk

(4) The fact that the loans are underwater represent a substantial drag on the market value of the underlying loan

(5) Points (1), (2) and (3) suggest that the best way out of the current housing situation is to revalue the real estate and adjust the debt and equity components of that value to “market” levels.  (1) and (2) suggest that the losses are going to happen no matter what.  Either loans go into default and homes go into foreclosure or borrowers take a loss when they sell the home.

Point (4) suggests that write-downs are a value-enhancing proposition because it eliminates the default and foreclosure risk associated with negative equity.

(6) Because this proposition makes investors better off, rational investors acting in their best interest would be agreeable to such a proposal.

(7) As applied to mortgages that are currently found as the collateral pool for private-label mortgage-backed securities, because of collective action problems (first-mover disadvantage) and the structural impediments found in many loan securitization documents that result in coordination problems amongst investors or limit what servicers can legally do, investors are unable to transact.  Hockett describes this as a market failure.

(8) In order to facilitate a market for these transactions, government must step in to rectify the market failure.

(9) The most efficient way to address this purported market failures and sidestep the collective action problem is for municipalities to invoke eminent domain to seize the underlying mortgages.

The plans that MRP have proposed on behalf of potential clients are based on Hockett’s idea.  Having read the MRP presentation materials and FAQ, below is my best guess of the general framework these proposals follow:

(1) A  joint powers authority is established.  The purpose of the JPA is to implementing the plan to use eminent domain to acquire underwater mortgages (not real property)

(2) MRP proposes to manage and facilitate the eminent domain and loan restructuring process, which includes (a) raising capital for the program; (b) identifying properties and (c) arranging for the loan refinancing.

(3) While MRP’s website explicitly states that local governments may choose to target delinquent and defaulted loans, its presentation materials exclusively focus on performing loans that are tied up in a private-label mortgage-backed security. 

(4) Municipalities will use quick-take condemnation proceedings in order to get possession of the mortgages.

(5) As is required with a condemnation, bond investors will be compensated at an amount equal to the fair value of the loan, which MRP defines on Page 6 of the FAQ:

Fair market value is the price that a willing buyer would pay a willing seller, neither under any compulsion to transact. Similar sales of troubled loans in the secondary market exist and good evidence of fair value.  These sales occur at a significant discount to the fair value of the home because of the foreclosure discount – the market’s recognition of the cost in time, money and effort to foreclose on the homeowner and thereafter to maintain and sell the property.  We will use these market data points and supplemental methods including discounted cash flow modeling.

(6) The loans get restructured and refinanced in accordance with underwriting guidelines consistent with government-insured mortgages and then sold out to a government agency.

The whole process is expected to take twelve months or less.  MRP is expected to earn $4,500 per transaction.  Investors will make money on the proceeds spread between the loan principal at acquisition and loan principal at refinancing.

I can understand why local officials would contemplate this nuclear option.  Peter Dreier’s article in The Nation depicts conditions in housing that are still dismal, especially in the hardest-hit areas. 

In almost every part of the country, entire neighborhoods—and in some cases, whole cities—are underwater…Since 2006, when the speculative housing bubble burst, home prices have plummeted; homeowners have lost more than $6 trillion in household wealth. Many now owe more on their mortgages than their homes are worth. Despite rising home prices in some parts of the country, more than 11 million American families—one-fifth of all homeowners with mortgages—are still underwater, through no fault of their own. If nothing is done, many will eventually join the more than 5 million American homeowners who have already lost their homes to foreclosure……The problem is contagious. Communities with many underwater homes bring down the value of other houses in the area. Foreclosures alone have drained at $2 trillion in property values from surrounding neighborhoods, according to a Center for Responsible Lending study. The resulting decline in property tax revenues has plunged some cities into near-bankruptcy, lay-offs and cuts to vital public services…

Communities with large African-American and Latino populations have been hit disproportionately hard.  According to the Center for Responsible Lending, between 2005 and 2009, household net worth declines for African Americans and Latinos were 53% and 66% respectively versus a 16% decline in white households (see Page 18).

Local officials hoping that help would come from public policy responses at the federal level have been disappointed. TARP, as originally sold to the public, may have helped somewhat.  Instead, it became a bailout of the banks.  Modification programs like HARP and HAMP have not helped out as many people as originally anticipated.   Furthermore, to the chagrin of many people, the FHFA, the body that oversees Fannie Mae and Freddie Mac has refused to implement a White House proposal to allow principal writedowns on GSE loans.

It’s no surprise that local officials are trying to take matters into their own hands.  They feel let down by Washington. They know the banks are useless and they’re sick and tired of seeing their communities deteriorate.  Along comes MRP with an interesting albeit unprecedented idea, I’m not surprised to see people pay attention, especially when the pitch includes a promise that no taxpayer funds are involved.

Issues

Predictably, the plan was met by fierce resistance from lobbyists and other representatives of the financial industry including the American Securitization Forum, Securities Industry and Financial Markets Association, National Association of Realtors and others claiming not only that the proposed plan pitched by MRP is illegal if not unconstitutional, the groups also claimed that local officials should expect lawsuits and that such actions to seize mortgages from bond investors could have the unintended effect of choking off the market for certain kinds of mortgages (one such example is here).  Also, as predicted, supporters of the plan have fired back claiming that Wall Street is full of it, that they’re not interested in any solution and have also fired back accusations of redlining (examples – Peter Dreier and Matt Taibbi).

I’m not going to address anyone’s concerns.  I am going to list mine.  I am very against this idea.  I have serious concerns about this and those concerns involve the legality of the program, the potential litigation risk (which is high enough to kill any program before it starts), the valuation issues, the fact that previously proposed plans serve no public purpose despite claims to the contrary as well as the impact on the capital markets to the extent such a plan ever gets implemented.

• Legal issues

There are a multitude of them, and I’ll let the lawyers around here delve deep into those issues.  There are several constitutional challenges that can mounted against this idea involving the Takings Clause, Dormant Commerce Clause and Contracts Clause.  There are issues involving state law.  For example, as I understand it, our beloved Burt Likko indicated to me that the use of the quick take proceedings may not be the appropriate procedure for this kind of condemnation.  Again, people with a law background are better suited than I to address this, but the point I am trying to make is that no matter who ends up being right, the question of the program’s legality is not settled and could potentially take a long time to settle.  That said, my initial take is that a program of this nature, at least one that has been presented in the manner that it was by MRP, is unconstitutional on the basis that there is no public purpose and that the market pricing that is being assumed is below market and therefore does not satisfy the definition of just compensation.

• Litigation risk

Is 100%.  The investors with the most to lose have deep pockets.  They will fight this and hard.  This isn’t anything else to say about it.

• At best, the idea that this serves a public purpose is suspect

Page 5 of the MRP presentation has the following text:

Large volumes of defaulted mortgages result in neighborhood blight, abandonment, unkempt property and transience.  These factors exacerbate the already compromised housing economics in affected areas and accelerate price depreciation…

Municipal, county and state governments, and agencies, have a public interest in halting defaults and consequent neighborhood deterioration.

The Program provides a practical and efficient solution to this intractable dilemma.

If defaulted mortgages are the cause of the blight, then how does restructuring performing mortgages (albeit underwater) provide a “practical and efficient solution” to an intractable dilemma that has nothing at all to do with performing mortgages? The answer is that it doesn’t.  In order to accomplish the objective of heading off foreclosures, the people that need the most help, those that are in default or face imminent foreclosure, have to get that help.  Despite claims to the contrary, I don’t think that help is coming.****

According to research conducted by Credit Suisse in 2012 (see Page 10), the default probability within a five year period for a current loan at 140% LTV and a 660 credit score is currently 45-46%.  At the same time, as the LTV improves and the credit scores increase, the probability of default drops substantially.  The default probability for a current loan at 120% LTV with a 760 FICO drops to just over 8%.  In San Bernadino county, at the time the research was published, 50% of borrowers that were underwater never missed a payment.

Since knowing which performing underwater loans will default at some point in the future is impossible, logically, the only way to carry out the objective of preventing future foreclosures is to assume not only that all underwater loans will eventually default but also that the situation is so dire and near-term that action is required now.  All mortgages are treated as distressed debt; however, as I explain below, this poses significant problems.

• MRP assumption of market value is way off-the-mark(et)

MRP has all but said that it would use the same methodology that the market uses for the sale of distressed debt or MBS tranches with non-performing loans.  John Vlahoplus, Founder and Chief Strategy Officer or MRP, in response to critics, writes:

The typical letter also claims that the fair value of loans cannot be far below their face value, and that purchasing the loans would create losses.  Yet the FDIC recently sold a portfolio of underwater loans for only 43% of their face value, even though 80% of the loans were current, and only 20% were in default.

Using sale comparables to set pricing guidelines for the MRP program is misleading.  I can understand why MRP would want to do this, as this would justify the prices that MRP is willing to pay (read: has to pay in order for this to work).  However, there is a whole other market out there for whole loans, and the dynamics of that market tell a completely different story.  Per Felix Salmon:

What’s more, when performing underwater mortgages are traded, they’re often sold above par, since the homeowner is locked in to higher-than-prevailing mortgage rates. MRP, by contrast, is determined that it will only buy mortgages well below par: indeed, they’re saying that they’ll demand a discount not only to the face value of the mortgage, but even to the market value of the property. As a result, deciding a fair price might well be completely impossible: the owners of the mortgage would value it as a performing loan at a high rate of interest, while MRP would essentially ignore the fact that it’s performing, and value it on the basis that it cannot be worth more than the value of the collateral.  A free market copes quite easily with huge valuation discrepancies like that: there’s simply no trade, and the owner of the mortgage holds onto it, while companies like MRP find themselves unable to offer a price at which anybody is willing to sell. That’s why MRP’s whole idea is contingent on doing an end-run around the free market, and forcing the owners of the mortgage to sell. The point here is that if there really was a low market-determined fair price for the mortgages, then MRP wouldn’t need eminent domain at all: it could simply buy up those mortgages on the free market, directly from banks. Maybe, eventually, once it ran out of free-market mortgages to buy, MRP could try to use the eminent-domain method to buy mortgages from CDOs and MBSs. But at that point they’d have real-world market-based proof of how much such mortgages were worth.MRP isn’t going down that road, however, because it knows that no one will voluntarily sell them mortgages at the kind of discounts it’s looking for. Which is prima facie evidence that the amount it’s willing to pay is not a fair price after all.

This is correct.  If I have a loan that MRP or some similar group wants to acquire and they propose 43 cents on the dollar and present this sale to me as the market, my response is three-fold:  First, comparing portfolio transactions to whole loan transactions is comparing apples to oranges and therefore wholly inapplicable.  Second, the seller is the FDIC and not a lender that is under no obligation to sell (FDIC sales (fire sales) do not qualify as market transactions).  Third, based on a small amount of research done on the transaction, there’s this:

Self-Help FCU paid $59 million for the loans and assumed the loans as part of a partnership with The Resurrection Project, a community development organization in Chicago that had raised the alarm about the possible eventual fate of the loans.  Resurrection had feared that FDIC would sell the loans to the highest bidder which might, in turn, increase foreclosures on the lenders.

Fair enough.  The FDIC had higher bids and could have gotten higher proceeds; however, it chose to accept a lower than market price to sell to this group.  It’s an easy thing to do when the seller isn’t a profit-motivated entity conducting a fire sale.

This point is very important.  Not only are there constitutional concerns regarding the appropriate level of just compensation, but also if the values that are required by law mean that the profit margins become very thin for investors, changes are very good that investor interest in this opportunity will wane.  This kind of uncertainty is enough to keep investors, at least the more conservative institutional investors, on the sidelines until these issues are resolved.

• Flaws in Hockett’s assumptions

Although I was impressed with the way Hockett laid out his arguments and found many of them to have some measure of credibility, they seem to be less applicable in the 2013 capital markets as they may have been in 2009.  The fact that bond investors that currently own pieces of private-label MBS deals oppose this plan is a sign of these flaws.  I think the biggest flaw is that while the valuation dynamics in housing will drive the valuation of the securities, it does not mean that there is no chance for people to make money without loan modifications.  The underlying mortgages don’t have to be written down in order for investors to take losses.  Investors can simply sell the securities.  That investors may be better off with higher expected values becomes moot if investors would rather take their losses and simply exit the asset class rather than spectate a modification process to determine the value.

For investors that are bullish on the asset class and have bought at significant discounts to par value already, they may have completely different opinions on the value of the loans that are performing yet underwater.  Based on the LTV, credit score, the region and conditions in the housing markets, among other things, investors may view these loans as having a lower-risk of default.  These investors will view a loan modification as having a negative impact on expected value and therefore not in their best interests.  In Point (5) above, I make the case that in order for a loan modification to have a positive increase in expected value, any decrease in cash flows will have to be more than offset by a decrease in risk.  This would take a substantial decrease in the discount rate investors use to value the cash flow stream.  If investors view performing loans as having lower risk, the discount rates will already be low.  The decrease in value due to lower cash flows will not be offset by the increase in value attributed to having less risk.

Final Thoughts

I’ll leave it at this for now.  There are several other concerns that I have, especially with respect to the impact that the use of eminent domain in the way discussed would have on the capital markets as a whole.  As it is, what I’ve listed above should be enough to communicate my belief that this is a terrible idea.  That no community has stepped forward to be the first one to try this plan tells me that even if local officials like the idea, when it comes to pulling the trigger, they see too much risk.  Also, my sense is that raising capital for a project like this is challenging and will continue to be a challenge until a municipality successfully executes the plan and bear the anticipated benefits.

****  While I think the offer to include mortgages in various stages of delinquency/foreclosure into a plan is a good way to pay lip service to the plan’s critics, the risk characteristics of these mortgages and proposed alternatives (i.e. a leaseback scenario) are so much greater that I think the only way this works is through a separate plan, one that may have limited attractiveness to the capital markets.  I’ll leave it at that.