Eminent domain, a well-established practice by which local governments forcibly purchase property to facilitate projects for the community’s good, could have been an elegant way to deal with long-standing problems facing distressed borrowers in mortgage securitizations. For instance, delinquent mortgages could be bought out of securitizations and sold to investors who would modify them. Localities could also ue it to clear up zombie title or buy distressed real estate (where the mortgage securitization is holding blighted homes because the servicer is holding off on recognizing losses).
But as we’ve written, the private equity firm Mortgage Resolution Partners looks to be well on its way to getting the good uses of eminent domain torpedoed by getting some not-too-swift municipalities to sign up for its self-serving scheme. One indicator of how dubious the MPR program is that investors who have been complacent in the face of all sorts of abuses by originators and servicers, have roused themselves to act in a unified manner and push back against the MRP plan, in the form of a suit filed in Federal court in California on Wednesday.
Key to understanding why this plan is a terrible idea and why investors are outraged is that there is a large gap between MRP’s well-funded messaging and how its program would actually work. The key thing to understand is that MPR’s plan isn’t about helping distressed borrowers. If communities wanted to condemn delinquent or defaulted mortgages, they don’t need MRP. It wouldn’t be hard to find dozens of hedge funds and other investors to bid on them and their aim would be to restructure the loans. And investors would be delighted to see this happen. Investors and homeowners lose in foreclosures. Both would do better with a modification, provided the borrower still has a reasonable income. It’s the servicers who win by continuing to wring servicing, foreclosure-related, and junk fees out of the securitizations.
MRP’s initial effort was with several government entities in the San Bernardino, California area. They signed up with a plan to condemn performing mortgages, meaning ones where borrowers were paying on time. MRP and the San Bernardino cohort tried passing off the canard that because the homes were underwater, the mortgage was worth less than the value of the house. No, sports fans, with a collateralized loan, the collateral is a backup source of value. It reduces losses in the event of default. You look to the borrower payment stream as the primary source of value. These were all seasoned mortgages, five years or more of current payments. These are borrowers who are clearly committed to keeping their homes and have income to do so. An arm’s length transaction would allow for some risk of default due to death, disability, or job loss, so a mortgage with a face amount of $300,000 would not go for $300,000. But if you have a current borrower with a solid payment history, you wouldn’t expect it to fetch much less than $250,000.
But the MRP scheme relied on condemning those mortgages at a large discount to their value by the bait and switch of claiming the mortgage value was based strictly on the value of the home, which is inaccurate, and then arguing for a discount from that. Look at how much the investors get ripped off, per this summary from Nick Iimiraos of the Wall Street Journal last year:
For a home with an existing $300,000 mortgage that now has a market value of $150,000, Mortgage Resolution Partners might argue the loan is worth only $120,000. If a judge agreed, the program’s private financiers would fund the city’s seizure of the loan, paying the current loan investors that reduced amount. Then, they could offer to help the homeowner refinance into a new $145,000 30-year mortgage backed by the Federal Housing Administration, which has a program allowing borrowers to have as little as 2.25% in equity. That would leave $25,000 in profit, minus the origination costs, to be divided between the city, Mortgage Resolution Partners and its investors.
The difference between my working figure of $250,000 and $120,000 is a whole chunk of change. You can see why investors are irate.
And remember, these investors aren’t for the most part hedgies. They are state and local governments, hospitals, Fannie, Freddie, and to a lesser degree, foundations and endowments. Thus when these investors fall short, the taxpayer often picks up the tab in terms of increased taxes or local fees of various sorts. You’d wind up paying for this scheme in the end, whether you recognize it or not.
And why did the math have to work that way? MRP was going to arbitrage the government by refi-ing the condemned mortgages into FHA loans. As we wrote last year:
…the very act of condemning with an intended takeout at a higher price via a Federal government program smells an awful lot like a scheme to defraud. Clearly the ability to refi ad a much higher price than the condemnation price is proof in and of itself that the condemnation price was too low.
The San Bernandino effort was shut down, mainly for reasons of local consternation (various officials had cut a deal with MRP in private and had not made required disclosures on a timely basis). But MRP is back, this time with Richmond, a town in California that the recovery bypassed. How can you not like the headline: feisty mayor bucking big bad guy financiers? And that’s the hope, that you won’t go beyond the headline.
The Wall Street Journal reports on a lawsuit just filed by two major securitization trustees (Wells and Deustche) at the behest of bond heavyweights that include Blackrock, Pimco, Fannie and Freddie. The suit was prompted by Richmond sending letters asking to buying 624 mortgages on homes in the jurisdiction and saying they’d condemn them if the servicers did not cooperate. The key bit is that 444 of these loans are current. You’d think if Richmond wanted to make sure that they’d get this program off to a good start (as in have the right optics) they’d be proposing to condemn only delinquent or defaulted mortgages. The fact that over 2/3 are current is another indicator that this scheme works economically for MRP only if a large majority are current.
Other warts: the San Bernandino, and we assume this version, did NOT touch Fannie and Freddie mortgages (MRP was concerned that they’d besubject by Federal pre-emption from action by state authorities). We have been told by Vince Fiorillo, head of DoubleLine Capital, one of the plaintiffs, that the plan also steers clear of mortgages with second liens, which includes home equity lines of credit. So even if this plan were everything it was promised to be, it would in fact only help a subset of borrowers, and that by targeting the type of mortgages where investors would be less likely or able to fight back (Fannie and Freddie are presumably among the instigators of this suit not in their capacity as mortgage guarantors, but by virtue of owning subprime mortgage bonds in their investment portfolio).
Last year, we had also spoken to California attorneys who specialize in eminent domain, and they read the MRP program as running afoul of several requirements of eminent domain in that state (a big one being valuation, California require that the municipality pay over market value and has property-owner-friendly methods for determining what market value is). But the opponents to MRP are advancing a legal argument that would be applicable in all states, so that if they prevail in this action, the odds of any other local entity taking up this program would be thin indeed. From the Wall Street Journal:
The lawsuit alleges that the proposed use of eminent domain is unconstitutional because it benefits a small group of Richmond citizens at the expense of out-of-state investors, violating the law on interstate commerce. The lawsuit also argues that loans aren’t being seized for a valid public purpose—a key criterion for a city that invokes eminent domain.
MRP’s defenses are pretty strained:
An MRP representative said it was confident its proposal is “entirely within the law.” “No investor in any trust will be made worse off by the sale of any loan,” said a company spokesman.
The suit by contrast, alleges that investors will lose $200 million or more on the Richmond operation alone. If this litigation proceeds (as in Richmond does not lose nerve and fold), it appears that the MRP contention that buying current mortgages on underwater homes at a meaningful discount to the value of the house will be subject to pretty harsh scrutiny. There’d be no basis for a claim that investors would lose money if MRP really were buying mortgages at market value.
That’s clearly nonsense. Pretty much any mortgage professional who is not on or hoping to get on MRP’s meal ticket would say so. The one point that Richmond does have right is that the servicers (and more important, the trustees who are supposed to discipline or fire the servicers when they aren’t doing their job) haven’t done mortgage mods. But that 444 out of 624 mortgages being current belies the idea that this program is really about mods, as opposed to buying local votes with out-of-area investor money.
Notice that the unhappy investor side filed this suit in Federal court. I would assume if they were to lose the Federal suit, they are not precluded from then fighting suits in state court alleging violations of eminent domain precedents in California.
So all in all, we have what looks like a sorry: a promising mechanism for cutting the Gordian knot of bad incentives in securitizations that will probably wind up being nixed for legitimate uses thanks to an overreach by a private equity fund. Well played.