US housing finance: The imminent pain of eminent domain

Louise Bowman
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The future structure of housing finance in the US might well not be decided on Capitol Hill or New York, but in a small, working-class suburb of San Francisco.

In July the town of Richmond, California (population 100,000) became the first municipality in the US to propose the forcible purchase of mortgages using eminent domain: the power of the government to obtain property without the owner’s consent. Richmond recently issued letters to the owners of 624 underwater mortgages (for which the value of the property is less than the mortgage outstanding), offering to purchase the loans at a substantial haircut. These mortgages would subsequently be refinanced to reflect the true value of the property. If the holders of the mortgages refuse to sell them, the loans will be seized under eminent domain.

There are big implications; according to Bloomberg roughly 20% of US households with a mortgage – 9.7 million people – have mortgages that are underwater. That translates to $580 billion in negative equity.

The Richmond scheme is being proposed by Mortgage Resolution Partners, which describes itself as “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”. Richmond’s letter gave the owners of the mortgages until August 13 to respond. And respond they did – with investors including Pimco, BlackRock, DoubleLine Capital, Fannie Mae and Freddie Mac launching a lawsuit against the scheme on August 8 via trustees Deutsche Bank and Wells Fargo.

MRP has been hawking this idea for roughly a year, but Richmond is the first municipality to bite. It was first considered roughly a year ago by another California municipality, San Bernardino, and has subsequently been looked at across the country from Chicago to Brockton, Massachusetts, to North Las Vegas, Nevada. The scheme seems particularly focused on California, where private-label loans have suffered more severe credit deterioration than in other states and because home loans in California are for all practical purposes recourse only to the house, not to the borrower. This is a result of the state’s anti-deficiency policy, which is designed to discourage speculative lending.

Richmond’s decision seems to have caught the finance industry unawares and has provoked fury among investors and banks alike. “If you invest in private-sector pass-throughs and someone is able to take performing loans out of the portfolio at less than market value, that is a huge deal,” says Barbara Novick, head of government relations and public policy at BlackRock. “The increased uncertainty and increased cost of protecting your rights is the most concerning aspect of this.”

More mortgage-related litigation is the last thing that the RMBS market needs, but it looks as if it is going to get it. “Contract abrogation and rule change are among the main impediments to the securitization market’s growth,” says Michelle Russell-Dowe, managing director and head of securitized products investments at Brookfield Investment Management. “Eminent domain is a troublesome headline, in particular with its proposal coming at a time when many housing markets seem to be improving, with downside far more limited.” Jim Ahern, global head of securitization at SG CIB, agrees. “MBS are created on the basis that they are due diligenced to a stable legal environment,” he says. “Eminent domain would undermine the market and prohibit private investment. It does not benefit anyone funding mortgages and will be heavily contested by the market.”

John Vlahoplus, founder and chief strategy officer, MRP
This prospect does not seem to faze the team behind the plan. John Vlahoplus, a soft-spoken Rhodes scholar with a doctorate magna cum laude from Harvard Law School, is founder and chief strategy officer at MRP. “For hundreds of years it has been the law that the government has the power to compulsorily purchase contracts through eminent domain,” he tells Euromoney, patiently. “This does not in any way impair or abrogate the contract, and has been done for many kinds of contracts. There is significant precedent for doing this.” He explains that while many of the loans are still current, they are highly risky. “The city has offered to buy precisely the kinds of toxic loans in non-agency securitization trusts that Freddie Mac just disclosed suffer from particularly severe credit deterioration, are more likely to default than loans in other states, and have higher likely losses given default than loans in other states. These are toxic loans, and their fair values reflect that,” he says. “Even though they are still current they have a high likelihood of default. Some of these pools of mortgages have suffered staggering losses – if they were banks they would have been taken over by FDIC and the loans would have been sold.”

What has particularly provoked the ire of investors is that 444 of the mortgages slated for seizure – more than two-thirds – are current on their payments. However, Vlahoplus points out that the Federal Deposit Insurance Corporation recently sold a $141 million pool of Chicago mortgage loans to a credit union in North Carolina for which 80% of loans were current. The credit union paid $59 million for the portfolio – just 42% of principal. MRP argues that the goals of its scheme chime with those of the US government’s Home Affordable Modification Program (Hamp), which allows certain borrowers with loans originated before January 2009 to change the terms of their mortgages to lower their monthly payments. The scheme, which has had a much lower take-up than expected, was recently extended to January 2015. It is intended to reach borrowers for whom default is imminent despite the fact that they are current on their mortgage payments. This is because loan modifications are more likely to succeed if they are made before a borrower misses a payment. Between 30% and 40% of borrowers that modified their loans since 2010 have subsequently defaulted.