As noted in my look at Mortgage Resolution Partners’s pitch to San Bernandino, MRP focuses on condemning the loans of current underwater borrowers. From an investor standpoint, that makes some sense because the borrower’s refinancing should be easy. But from a deal economics and public policy view, it arguably makes much more sense for the Authority to focus on defaulted loans.
Defaulted Loans Are Super Cheap And Valuations Clearer
For starters, the ‘just compensation due’ would be trivial, compared to the price of current loans, meaning the Authority would need to borrow much less money. Second, those amounts would be harder to litigate as there are many more transparent comps. Third, it’s much harder for a bank to prop up the value of its home equity loan/2nd lien when the first is in default, so taking 2nds should involve much less litigation risk too. Fourth, because the defaulted underwater loans are worth so little, the spread between the condemned loans and the refinanced ones should be enormous. The Authority should be much more sanguine that there’d be, enough to repay investors, cover litigation costs, and leave some left over for the Authority.
While taking current underwater loans serves more of a public purpose than the generalized economic development claim of turning homes into property for Pfizer, taking defaulted loans provides even more public benefit. Instead of diverting some properties from foreclosure by refinancing them while they are still current (while also refinancing ones that may never have gone into foreclosure, or at least not soon), every defaulted loan taken is a home saved from foreclosure in the very near term.
Foreclosures depress property values around them; ‘taking’ homes back out of the foreclosure process helps the neighbors, the overall tax base, and the housing market. Moreover, people en route to foreclosure have generally not been able to maintain their homes as well as they’d like. Newly stable homeowners with affordable mortgages are much more likely to put on that new roof or do other repairs, which stimulates the economy.
Taking defaulted loans raises three risks, however, not really posed by taking current ones. First, there’s the chance that the homeowner, credit now destroyed, cannot refinance into even a market value mortgage. Second, there’s political risk. Third, there’s ‘moral hazard’. All can be effectively minimized.
Minimizing Refi Risk on Condemned Mortgages
The risk that a defaulted homeowner who could afford a market value loan could not, nonetheless get one because of the mortgage default history, can be addressed in at least a few ways. First, the Authority could work out an equity sharing deal with the homeowner such that the homeowner only borrows 70-80% of the home’s value, which would greatly increase the chances of a successful refi, while insuring the Authority eventually received most or all of that largess back.
Second, the Authority could hold the note for, say, seven credit-clearing years, while using excess cash from successfully refinanced properties to repay investors for the just compensation lent in the ‘hold the note’ cases. Third, the Authority could condemn the home (it would pay itself the just compensation) and then sell it.
At the national and even state level, the biggest blocker to effective public policy on housing has been the idea that irresponsible borrowers caused the crisis and that helping people in default amounts to the righteous bailing out the unworthy. Regular readers know how little I think of this claim, and how the evidence is overwhelmingly against it. But the idea is nonetheless politically potent; even MRP addresses it on their website by putting up two FAQ:
Is your program a giveaway to the undeserving who borrowed more than they should have to purchase houses they never should have owned?
No. Everyone in California has the opportunity to purchase a home by borrowing from a lender who is willing to take a loss if home prices decline by more than the homeowner’s down payment. The lender willingly takes the risk when making the loan, and the fair market value of the loan reflects that risk. By purchasing the loan at fair value, we give the lender the benefit of its bargain. By doing an economically rational modification or other resolution with homeowners, we afford them the benefit of their bargain without forcing them to default and flood the local housing market with additional foreclosed homes.
Regardless of the legal niceties, is it just wrong and a moral hazard to let these homeowners stay in their homes?
No. We protect our neighbors’ homes, even allowing them to keep the equity in their homes while canceling their debts in bankruptcy, because it is the right thing for them and the right thing for us. In the U.S. we do not put our neighbors into debtor’s prison, or make them homeless unnecessarily. America is facing an economic crisis and the solution requires practical action that keeps people in their homes which benefits the entire community. The real moral hazard is that the system is forcing homeowners to default in order to achieve rational solutions.
While MRP’s answers are tailored to the current homeowner, rather than defaulted one, it doesn’t take much tweaking to apply it to them too. Moreover, when acting at a local level, this kind of pr-scare tactic is counteracted by people actually knowing some of the homeowners involved and seeing the direct benefits of the program working. Partnering with a community organization or two could also help with this issue. Finally, to the extent that the political risk manifests, using an independent authority to do the program, as San Bernadino is, helps deflect it some.
The moral hazard claim is ‘if you take defaulted mortgages, you reward people for defaulting and inspire other people, now current, to default.’
Before taking on the claim, let me preface by saying that I find it incredibly offensive for policy makers to worry about the moral hazard involved in letting homeowners shift some of their losses to creditors by strategically defaulting, when some of those creditors are the bailed-out banks who continue to display the reckless behavior engendered by bailing them out–can you say ‘whale’ Jamie D?
Bailing out the banks without holding them accountable–and our continuing failure to hold them accountable–has created a moral hazard in our financial system that this globally destabilizing. And the policy makers who created that moral hazard are sweating whether the plumber down the street defaults to get his mortgage restructured?
Be that as it may, if our incredibly punitive, anti-debtor policy makers want to prevent current underwater borrowers from defaulting to participate in the eminent domain program, all the local government need do is say they will only take mortgages that were in default as of the day the program is announced.
As to ‘rewarding’ the defaulted homeowner for defaulting? Well, policy makers need to stop being so myopic. First, the homeowner has already been ‘punished’–credit destroyed, emotionally devastated, physically harmed by the stress. Second, the taking and refi isn’t about the helping the homeowner, it’s about helping the community by diverting foreclosures, stabilizing communities and housing prices, protecting the tax base, and stimulating the economy. All those benefits should be ignored because of misplaced outrage that a defaulted homeowner gets to stay in their home while paying the bills they now owe?
The expression ‘cutting off one’s nose to spite his face’ isn’t extreme enough to illustrate how crazy that attitude is.
Bottom line: as San Bernadino moves forward with its plans, I hope it will reject the MRP current loan focus but otherwise adopt the plan for defaulted loans. And I urge other communities to do the same.