By Abigail Caplovitz Field | July 12, 2012
Every government in the United States has the power to take private property for a public purpose, so long as the former owner is paid ‘just compensation.’ And post-Kelo, we know that “public purpose” is very broadly defined. So can eminent domain be useful in solving our housing and foreclosure crisis? Maybe. The details matter.
The San Bernandino Approach
Eminent domain is the housing market solution du jour because San Bernadino County, California, and two of its largest cities, have formed an Authority to possibly take loans using eminent domain. According to Housing Wire, the communities have been approached by Mortgage Resolution Partners (MRP) and two nonprofits with plans to take underwater mortgages and refinance them at market value. A public hearing will be held by the Authority this Friday, 9 a.m. PDT (webcast available here, agenda here.)
Most of the agenda involves constituting the authority that would wield eminent domain, but listed too is the critical “public comment” opportunity. I encourage you to listen in to at least that part of the meeting, and if you can show, to ask questions. In this post I hope to arm you with enough information to ask good questions.
Despite Housing Wire’s report that two non-profits also pitched San Bernandino on eminent domain plans, the only plan somewhat disclosed to the public to date is MRP’s. So that’s the one I’m analyzing now. Based on MRP’s FAQs, information it is circulating to interested parties, and various media reports, here’s the basic deal:
First MRP/the Authority finds mortgages they want to take: people who are current on their mortgage, who are underwater, and whose mortgage is ‘owned‘ by a private-label mortgage-backed securities trust.
The Authority then takes the mortgage, a process which includes filing a court case. To pay “just compensation”, the Authority deposits money with the court, in the amount the Authority deems fair market value of the mortgage. That money comes from investors. At that point, the securitization trustee/servicer that manages the mortgage takes the cash
or the case proceeds to trial on just compensation.
Update: The litigation risk is higher than I originally thought; if the trustee takes the cash, they can still litigate the compensation, but they cannot litigate the taking itself.
Regardless of whether the compensation amount is litigated, once the mortgage is taken, the Authority tells the homeowner: if you get an FHA-approved lender to issue you a mortgage for 97% or so of your home’s current market value–that is, a mortgage that gives the homeowner a smidge of equity, enough to qualify for an FHA mortgage–we’ll accept that pay off amount for the mortgage we just took.
And voila! The homeowner has a much more affordable mortgage that allows her to build equity with each monthly payment; the original bank got what its mortgage was worth; and in the payoff from the new loan, the authority got more than it spent to buy the loan. The authority uses that excess to pay the investors, cover its costs, and perhaps profit.
What could go wrong?
The Deal Economics Hinge on Litigation Risk
Well, let’s start with the economics: for the deal to work, the difference between the price that the authority pays as just compensation for the current, underwater mortgage has to be significantly less than 97% or so of the home’s value. That spread is what provides the cash to pay back investors, including their rate of return (how much is that?), to pay MRP (how much?), and to cover the Authority’s costs.
MRP is confident it can justify the discount the authority pays on the underwater mortgage, citing auctions of similar mortgages, the likelihood that these underwater mortgages will eventually default, and the huge losses that result after default. But if the securitization trustee disputed the valuation, the counter argument would be: ‘look, the loan’s current; it’s worth more than the house, not some percentage of the house.
‘Yes, underwater loans tend to default more than others, but averages don’t speak to this particular mortgage’s chance of default. And hey, when our mortgages default, our servicer’s reasonably good at getting them performing again through interest rate and forbearance modifications and other tactics. So this loan’s worth more than you say it is.’
These arguments don’t have to be winners; litigation can be an end in itself. Rather than win, the trustee need only drive up legal fees and create real uncertainty as to outcome to make the deal falter. The trustee can always take the cash or otherwise settle with the authority at a later date.
That litigation risk is real, because MRP/the authority wants to pay significantly less than the value of the underlying home even though the loan is current. But the litigation risk may be much smaller than it otherwise seem because of the mortgages MRP/the Authority are targeting: loans owned by private label securitization trusts. Private securitization trustees/servicers are generally disinclined to act and the investors behind them relatively powerless. Laurie Goodman explains:
“We believe (the choice of target) reflects the fact that private-label securitizations were poorly designed — the private-label structure does not provide for a responsible party whose duty it would be to ensure that such a taking was legal and the fair market price was actually fair”
MRP responded to Goodman by critiquing her fair value concerns. It was silent on the litigation risk angle. Regardless of whether MRP’s valuations are right, it’s targeting of private label securitzation loans is surely a litigation risk minimization tactic. Similarly, if MRP targets only a few loans from any given trust, it further reduces the chance that it would rouse the trustee.
If MRP has in fact successfully minimized its litigation risk, then the deal might actually work. But we can’t decide that risk is minimized without understanding the approach on second liens–traditional second mortgages or home equity loans.
MRP says that in its approach, second liens would also be taken if the lien owner doesn’t want to sell at the price MRP/the Authority values the loan at. If in its screening of mortgages, it targets only ones with privately securitized seconds, the litigation risk strategy holds. But many or even most second mortgages are held by banks. And the banks are valuing their seconds very high, making them unlikely to accept MRP/the Authority’s valuation. That is, taking bank-owned seconds may represent high litigation risk.
Conversely, if the program will only involve current, underwater mortgages securitized in private label deals the either have no second or have seconds that were also securitized in private label deals, how many mortgages are we talking about? Enough to make a difference?
Allocation of Risk
The MRP website says it will bear the risk of defending lawsuits against the program, presumably meaning defending the constitutionality of taking mortgages. That shouldn’t be a big risk, because mortgages loans are property and the public purpose easier to articulate than in Kelo. (E.g., unfreezing the housing market by making it suddenly possible for formerly underwater homeowners to sell and buy; preventing foreclosures and all the collateral damage; stimulating the economy by putting cash back into homeowner’s pockets.)
The big litigation risk is the one above–valuation litigation. And that risk is a) the litigation fees, b) the possibility of having to come up with extra cash to pay more compensation, c) collateral consequences of the program getting stuck. If there’s lots of litigation, that could be big money.
The website also notes that since the investors are putting up the just compensation money, their security is the underwater mortgages purchased with it, and nothing more–no recourse to the Authority. That’s good, but not a very big deal. The investors don’t face a real risk of not getting their cash back. That is, the investors get paid as soon as the new loan is done and the homeowner ‘pays off’ the underwater, condemned loan with it.
So there’s only three ways the investors won’t get their money, and none is likely. First, the homeowner refuses to refinance into the desired market value mortgage. Why would that happen? Second, the homeowner tries to refinance but can’t. That’s unlikely, because the targeted borrowers are current on more expensive loans, the new loans won’t be underwater and are intended to be government-guaranteed. That makes the loans attractive to hold or to sell into the securitization market, which still exists for government backed loans.
Third, the price of the just compensation might be so high relative to the new mortgage that there’s not enough spread to pay the investors their return. That’s unlikely, because the whole point is that the Authority/MRP sets a just compensation price that makes the deal economics work, and that’s what the investors ante up.
So while it’s nice that the investors’ loans to the Authority are non-recourse, it’s not very important.
In short, the big risk everyone needs to keep their eye on, and ask about at the hearing is:
Does the Authority bear the valuation litigation risk alone, or do the investors or MRP share in it?
Regardless of whether San Bernandino ultimately goes with RFP or one of the nameless “nonprofits” in HousingWire piece, when contracts are being drafted–apparently we’re not even at the RFP stage yet–the litigation risk provisions are going to be key.
AMRP’s website says this about how it gets paid:
“How is MRP paid?
The community does not pay MRP. The funder pays MPR a fee for each loan acquired by the community. This fee is very similar to the fee paid by the government to banks that modify mortgages under federal programs. The MRP fee does not depend on the price the community pays for the acquired loans.
While it sounds good so far as it goes, it simply means MRP’s fees are priced into what the Authority (“the community,” in this case) pays the investors (“the funder”) for access to the investors’ money. So how much is that fee?
Transparency has to be a real cornerstone of both the final deal and of the process of getting there. The public needs to know what risks its being asked to bear, for what rewards, and who else is benefiting by how much. California recently abolished Redevelopment Authorities statewide. The abolition was primarily for fiscal reasons, but succeeded in part because the Authorities were a cesspool. San Bernandino’s special Authority for this deal should do all the things right that the dissolved authorities got wrong, and that starts with transparency and accountability.
So do I support the MRP approach? Not really, because I think the program should focus on defaulted rather than current borrowers, as the next post explains. But if the MRP approach works as sketched, and the ultimately disclosed rate of return to investors isn’t gross–everything hinges on contract text, of course–it’s much better than nothing. Again, IF the approach works as promised…