US housing finance: The imminent pain of eminent domain
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.
Vlahoplus argues that initiatives such as his are necessary to get mortgage finance in the US functioning properly again. “Until we clear out the pipes we do not have the ability to bring back private-label securitization for non-jumbo loans,” he says. “When you hit a financial crisis, those companies that sell underwater assets survive and those that deny the fair value of their assets don’t. We need to clear out the pipes and restore trust.”
Not surprisingly, investors feel rather differently. “Eminent domain would be a real shift in the concept of ownership in this country – we are fundamentally opposed to it,” says Najib Canaan, managing partner at Marinus Capital Advisors, a Connecticut-based asset management firm. “If it goes through, it will break the new-issue market. Private capital will not re-enter the market unless there is clarity on the risks.”
The industry argues that while the scheme claims to help neighbourhoods that have been blighted by negative equity, it will actually hinder them by making mortgage credit more expensive in future. This is because investors, unable to hedge this risk, would simply refuse to invest in pools of mortgages from areas that had enacted such legislation. “Can I price that risk?” asks Russell-Dowe. “You can price for prepayment, default and liquidity risk but how can you price for, or hedge, eminent domain risk?”
Vlahoplus dismisses any suggestion that the market will refuse to securitize loans from these neighbourhoods. “Securitizations have been done since our programme became public. The risk disclosure specifically cites the risk of loan condemnation yet the deals have gone off without a hitch – in some cases oversubscribed,” he says. “Obviously no city has condemned loans yet, but for Wall Street past performance is no predictor of future results. Whether any particular city condemns loans now is irrelevant; the fact is that cities, states and the federal government have the authority to do so, and in the future you never know whose market will be crushed and therefore which government or location might condemn loans. So you have to price it in now; the market is certainly pricing it in now, and there is no indication that it is restricting credit or increasing interest rates.”
Some investors have questioned the extent to which new private-label deals are spelling out the risks of eminent domain, but when Euromoney looks through the prospectus for a Redwood deal last September (Sequoia Mortgage Trust 2012-4 in September via Barclays) the situation is clearly outlined.
However, in an indication of the magnitude of force being marshalled against this plan, the Federal Housing Finance Agency itself issued a strongly worded statement on August 8, which declared that the agency would, among other sanctions, “limit, restrict or cease business activities within the jurisdiction of any state or local authority employing eminent domain to restructure mortgage loan contracts”. And on August 29 the Structured Finance Industry Group (SFIG – the new industry lobby group formed after the resignation of the majority of the board of the American Securitization Forum earlier this year) filed an amicus curiae brief in support of the investors’ lawsuit, stating: “While SFIG recognizes the challenges currently confronting municipalities and borrowers, the use of eminent domain to seize mortgage loans is an illegitimate tactic that undermines the integrity of the entire home mortgage system. Allowing this type of practice is a short-sighted and unconstitutional idea. Not only would it do irreparable damage to the private mortgage market, undermining Congressional efforts to encourage private capital in the market but it would also actually injure the local residents these efforts are supposed to be helping.”
It will take more than this to ruffle the feathers of MRP, however, which states that any attempt to restrict credit would run counter to California law. “This is a legitimate tool for local governments to use,” says Vlahoplus. “Any effort to restrict or raise the price of credit in these areas would violate anti-trust and anti-redlining laws in California.” Redlining is the practice of denying, or charging more for services to particular (often racially determined) areas and is illegal. “Any restriction of credit as a result of this is a discriminatory effect,” he says. “Invoking eminent domain protects minority neighbourhoods. This is not about protecting the borrower – it is about protecting the borrower’s neighbour. This is a local government decision. It is no business of the financial sector to tell Richmond what it can’t do even if Richmond thinks it might hurt credit. It is absolutely Richmond’s choice.”
Like so many other legacy issues from the sub-prime mortgage crisis, this is likely to end up in the courts for some time, something that Vlahoplus is clearly frustrated by. “The market needs somebody to cut through it, get the parties to the table and fix the loans,” he says. “Condemning the loans seems like the obvious way to do this. There is not a timeline in place to condemn these loans – the goal remains consensual agreement.”