While investigating homeowners’ inability to restructure securitized mortgages, Robert Hockett, a law professor at Cornell University, developed a novel yet aggressive strategy to alleviate their deepening negative equity problems.
Local governments could use eminent domain to seize and restructure those underwater mortgages for homeowners, who would then receive a new loan and get to remain in a home in which they now had equity.
The professor was and still is a consultant for Mortgage Resolution Partners, a politically well-connected San Francisco-based investment group. He motivated the firm to meet with a state official about the innovative use of eminent domain, which allows a government to seize — for fair market value — real estate for the public good.
And then in late 2011, MRP pitched the potentially controversial strategy to California’s San Bernardino County Chief Executive Greg Devereaux.
The move to approach the San Bernardino County government made sense: About 43% of the mortgages in Southern California’s Riverside-San Bernardino-Ontario metropolitan area are underwater, according to CoreLogic’s most recent data. The area suffers from an 11.8% unemployment rate — tied with Las Vegas-Paradise for the highest among metros with more than 1 million inhabitants, according to the U.S. Bureau of Labor Statistics.
The San Bernardino metro posted the highest foreclosure rate in May among the nation’s 20 largest metropolitan statistical areas by population, according to RealtyTrac. One in every 179 housing units had a foreclosure filing— more than 3.5 times the national average.
“Our problem is that some of these people are underwater so far that they’ve got no upside to continue making their payments,” says John Husing, chief economist at the Inland Empire Economic Partnership, an amalgamation of companies working to stimulate the economy of Riverside and San Benardino counties. “Our construction sectors have to a large extent shut down as a consequence of the mortgage crisis. Until that is resolved, we stay in a recession.”
A significant portion of the San Bernardino County economy is based on homebuilding and associated industries. “Many people believe our economy will not be healthy until homebuilding returns and many don’t believe that homebuilding will return until the mortgage crisis is resolved,” Devereaux says. “Therefore, we believe we have a responsibility to explore any idea anyone has to resolve part of the crisis in our county.”
MRP’s idea condemns performing underwater mortgages in private-label securitization at fair market value and then, using the Federal Housing Administration’s short refinance program, refinances them to a loan-to-value ratio of 97.75, just under the home’s fair market value, giving the homeowner a dash of home equity. The local government takes title to the loans, and pays the private-label security trusts with money raised by MRP. When the loans are refinanced, the proceeds are used to repay investors who financed the program.
Intrigued by the proposal, Devereaux went to his county board to discuss the viability of spending the resources and time to see if it would be interested in the idea. The board’s receptiveness gave birth in June to the Joint Power Authority — a group of representatives from San Bernardino County and the cities of Fontana and Ontario — to explore ideas about how to clean up the region. The JPA will issue a request for proposals in August to study relief plans from various groups, including nonprofits.
However, it also gave birth to a roaring opposition at a time when another battle is under way over the California Homeowner Bill of Rights, which also attempts to rehabilitate the state’s suffocating mortgage meltdown. The outcry comes not from homeowners — who welcome the notion relieving themselves of their negative equity — but from the investment and real estate community who view the program as unjust and an abuse of government authority.
Opponents also see it as a serious threat to the mortgage market as it offers a way to restructure underwater mortgages without costing taxpayers a nickel, a seductive sales pitch in today’s era of government budget deficits.
MRP, of course, has a different take.
“I don’t see this as interruptive to the financial system,” says MRP Chairman Steven Gluckstern. “I think it begins to recognize losses that have already been taken through the private-label security system. And more importantly, it begins to restore consumer confidence because this is a drag on the whole economy.”
If the proposal flies, MRP, which is in talks with a dozen other communities, including some in Nevada and Florida, could ignite a wave of innovative, yet controversial, strategies that employ eminent domain to attack the nation’s mortgage crisis.
The plan has the backing of famed economist Robert Shiller, who wrote about the plan in a New York Times op-ed, claiming that “the original mortgage holders, the investors in the new mortgages, the homeowners and the nation as a whole will generally be better off. There will surely be some who may not agree, like the holdout farmer opposing a new highway, but eminent domain ought to be able to push ahead anyway. We must hope this effort succeeds. If it works, it can be replicated all over the country.”
SEEDS OF AN IDEA
Putting aside MRP’s inherent mission to make money, the notion of using eminent domain to seize mortgages sprung from homeowners’ difficulty in restructuring mortgages that are part of a private-label securitization trust. “How can we get that loan from the trust and into the community — someone who would have an incentive to work with you. That was the origin of the idea,” Gluckstern says
The county has more than 150,000 homes with underwater mortgages, 20% of which are held by bundled securities.
Gluckstern estimates about $1 billion is needed to buy mortgages on 5,000 homes and says the company will seek private investors to keep taxpayers off the hook for startup costs. He says the program’s mission is greater than erasing the nation’s rampant negative homeowner equity. He’s trying to change homeowner behavior in an attempt to boost the overall American economy.
“The negative equity is a fundamental problem in the economic recovery because when people are underwater, their behavior changes in what they do and spend,” Gluckstern says. “If people feel underwater, they don’t buy a new refrigerator, television, they don’t fix up their house, go out to dinner — all of which are keys to having a recovery in this country.”
The American Securitization Forum, which has held detailed conversations with MRP about the mechanics of the plan, is disturbed by it and feels that the use of eminent domain will discourage investors from returning to investing in MBS.
“There’s a lot of opacity as to their fee structure,” says ASF Executive Director Tom Deutsch. “It’s clear that a private firm would not put in the work they’re putting in without trying to realize large returns.”
The project, simply and briefly put, would work like this: The community identifies a performing underwater mortgage in a private-label security. Through a process of adjudication, it’s determined that the local government will pay $100,000 for the loan. The homeowner then gets a new loan with a payoff of $110,000, creating a spread, or profit, of $10,000 for the parties involved.
Part of that profit will go to the financier who put up the money to buy the loan from the trust. Some of it goes toward paying the various costs of re-underwriting. Another piece of the profit goes to MRP in the form of a fixed fee based on the successful closing of the loan. And the rest goes to the community, possibly used for public housing.
“I think it’s interesting,” Devereaux says of the plan. “I can understand how it works from MRP’s perspective and I understand how it would benefit our mortgage market and local economy. What I haven’t heard yet are the potential downsides and unintended consequences because it hasn’t been publicly vetted.”
Once the JPA receives proposals in August, Devereaux expects to receive responses by the end of September and then respond in October. “Public benefit and helping our economy is my goal,” he says. “So far I haven’t seen banks or anybody else who’s holding these mortgages do anything at a sufficient scale to help our economy.”
INVESTORS FEAR PLAN
The swift and forceful verbal retaliation from financial trade groups reflects their proliferating concern that the idea is gaining momentum.
Investors fear the plan would not only result in massive prepayment risk for mortgage-backed security holders, but also impose losses on whoever holds the credit risk on the mortgages. They expect the market to demand a much higher risk premium going forward if eminent domain becomes contagious, as one would assume that there is massive prepayment risk whenever a loan is underwater, resulting in higher mortgage rates. Down payment requirements would rise, investors predict, with lenders wanting to minimize the likelihood that a loan ends up in a negative position and is thus subject to eminent domain.
Deutsch doesn’t think it is appropriate to target borrowers for restructuring simply because they’re underwater.
“If a borrower is current, it demonstrates they have an ability to pay their mortgage,” Deutsch says. “So although being underwater may be one characteristic of a potential defaulter, there is an overwhelming population of underwater borrowers who continue to pay on a timely basis. Current servicing practice is not to modify any old borrower who just happens to be underwater, so as a policy proposal this doesn’t seem to make a whole lot of economic sense.”
In June, 18 trade groups, including the Mortgage Bankers Association, National Association of Home Builders and the California Bankers Association, sent a letter San Bernardino County Board of Supervisors protesting MRP’s proposal.
The trade groups claimed that if eminent domain were used to seize loans, folks who invest in those loans through their investment portfolio would suffer immediate losses and hesitate to provide future funding to borrowers in those areas.
“Why would an investor want to effectively lend money through the securitization process to borrowers if the city can come back and take it away?” Deutsch asks. “So essentially the investors will own all the downside and the borrowers would own all the upside if home prices appreciate.”
Laurie Goodman and her team of analysts at Amherst Securities Group contend that if a loan were purchased out of a trust through the eminent domain strategy, the price would most likely be at some discount to the fair value of the mortgage, which would create a loss on the loan.
Gluckstern rebuts that premise, saying that private-label bonds are trading at deep discounts. “The bulk of the loans in the PLS have already taken a loss,” he says. “Those bonds don’t trade at 100 cents on the dollar because the owners know the odds of the homeowner paying the loan all the way down are likely zero — that they are eventually going to stop paying. That loan is probably already mark-to-market in the hands of the bondholder — they just haven’t relieved the homeowner.”
Amherst believes that the intent, which it says it confirmed by investors who have heard the MRP pitch, is to buy the targeted loans out of the trusts at 75% to 80% of a home’s market value, which is determined by an automated valuation model — and widely criticized as being inaccurate. But if the loans are purchased at 100% of the market value of the property, the firm says, the economics become much less appealing to investors funding the program and closer to fair value for the private-label security investor.
MRP claims that Goodman’s calculation of the fair value of a severely underwater loan in the JPA’s communities is flawed in that it uses an average default rate that underestimates the likelihood of default and is lower than Amherst’s own published default estimates.
AVMs are normally based on a mix of distressed and nondistressed values so in an area featuring many distressed sales, the AVM will reflect the mix, even though homes targeted for the program are neither distressed nor for sale.
“If somebody is carrying the loan at more than the fair market value that is eventually adjudicated in this process, might that financial institution have to take a loss? The answer is yes,” Gluckstern acknowledges. “That’s the economics, that’s not the intention. We don’t think it’s that big an issue.”
But investors see it as a big issue. And there are options available that they could take outside filing a lawsuit objecting to the legality of eminent domain in this context.
Investors could try to apply business pressure to stop the program by refusing to work with the servicers, originators and investment banks involved in the program. The strategy could work in many cases, but, as Amherst notes, some of these entities are not reliant on business from PLS investors.
Another route is that Fannie Mae and Freddie Mac step in on the side of PLS investors. Fannie and Freddie together hold $112.9 billion of private-label securities, more than 10% of all PLS outstanding so these portfolio holdings are clearly affected. If the Federal Housing Finance Agency and the GSEs stop insuring loans in municipalities using eminent domain to condemn mortgages, the program would come to an end.
SETTING A PRECEDENT
People on both sides of the issue appear to agree that eminent domain has never been used to buy mortgages. Still, proponents cite precedence in which state governments used the law to acquire other intangible assets such as leases.
The Fifth Amendment of the Constitution mandates that in order for the proposal to exercise eminent domain, it must satisfy two criteria to materialize for San Bernardino County, Fontana and Ontario to enforce it: It must be done for public purpose and necessity; and the property must be purchased at fair market value.
“Clearly there are many constitutional issues raised by this,” says Chris Katopis, executive director of the Association of Mortgage Investors. “I’m not sure how this serves a public purpose when it seems that MRP will be the chief economic beneficiary of this. It appears to me to be a land grab.”
Eminent domain, traditionally, gives the government the power to take property, usually real estate, at fair market value for a public project, such as a new road.
However, in 2005, the U.S. Supreme Court affirmed an expanded and controversial concept of eminent domain when it ruled that governments could use it to take private property if the taking results in public benefit. In a 5-4 vote, the justices ruled a redevelopment project qualified on the expectation of new jobs and increased tax revenues. Property rights advocates and dissenting justices opposed the decision on the grounds that it placed property rights at the whims of any elected officials who could be swayed by developers’ promises to
If the five-member JPA is allowed to use eminent domain to force investors to sell their loans and the approval is challenged in court — San Bernardino County’s experience could result in another precedent-setting case.
“I think there’d be a lot of hubris in saying that there is no legal concern as to whether this is an appropriate use of eminent domain,” Deutsch says. “By all indications, this program is designed and ultimately managed by a private company using the city and county powers of eminent domain. That in and of itself smacks of private capital trying to earn returns through this endeavor. That starts to sound like a private purpose, not a public purpose.”
Husing doesn’t see it that way. “Essentially, the power rests with the county,” he says. “Without the county’s eminent domain, there is no program.”
And he’s certain the financial community is working overtime to enact laws that will darken the program’s future. “They’ll be looking for their allies in Congress to do it,” Husing says. “Do I have a lot of sympathy for those people? I don’t have any.”
The ASF, meanwhile, is engaging advocacy efforts to try to convince the San Bernardino government of what it feels would be an unwise decision for its citizens. It’s also looking at potential legal challenges that may prevent the county from taking steps toward implementation. “In August, we will be in a position to provide a very detailed commentary on the unstable legal framework that they will be building the eminent domain seizure on,” Deutsch says.
Devereaux, on the other hand, doesn’t foresee legal obstacles. “Eminent domain is not just used to acquire property, but also interest — easements, leaseholds,” he says. “We’re putting homeowners in negative equity into positive equity. It clearly has been used to acquire other interests in property other than the property itself.”
Wonders Husing, “How long does our county want to sit at 11.8% unemployment?
“We can have a public tool used to shorten the time frame until this is over,” he says. “A public official who won’t do that better not give the speech that they want to do everything to help the economy because they’re not doing it.”