The city of Richmond, California, recently announced a plan wherein it would offer banks and other title holders fair market value for distressed assets, but if they refused they would seize those assets under eminent domain laws so that they could restore equity to the town and move those properties back into the market. Both banks and legal experts have challenged the move, however, and government-sponsored lenders Fannie Mae and Freddie Mac have warned that they may not secure future mortgages on the properties, which could keep the plan from moving forward. For more on this continue reading the following article from TheStreet.
Richmond, Calif. Mayor Gayle Mclaughlin is determined to go ahead with the city’s plan to seize underwater mortgage loans from investors using its right of eminent domain.
But the creative plan is ill-advised, according to legal experts. The proposal has a long shot at success in court and has serious repercussions for the City of Richmond.
Major investors holding the mortgage loans in question, including housing giants Fannie Mae (FNMA) and Freddie Mac (FMCC) and the likes of Blackrock (BLK) and Pimco, have challenged the constitutionality of the proposal, asking a federal court to stop the city from moving forward.
Federal agencies including the Federal Housing Finance Agency, regulator of Fannie and Freddie, and the Federal Housing Administration, have also raised concerns about the proposal. The FHFA has said it would consider directing the GSEs to restrict or cease activities in communities employing eminent domain to "restructure mortgage contracts," in order to protect its interests.
This could hurt the ability of Richmond homebuyers to secure loans.
The FHA has also expressed concerns about the use of eminent domain and does not know whether it will insure new mortgages in Richmond, pending legal developments and further execution of the plans in question. If the FHA does not back the proposal, it could be a major blow to the eminent domain plan, as the city intends to write down the loans seized from investors and then refinance them through a government-sponsored program such as those offered by FHA.
Investors have rejected the city’s offer to "voluntarily" sell mortgages at a discount to current property values. Banks including Wells Fargo (WFC) have said that loan servicers and trustees are contractually prevented from selling individual loans out of mortgage-backed security trusts.
It should come as no surprise that the proposal has the mortgage industry up in arms, as eminent domain overrides contract law.
Richmond’s Mayor believes banks have caused the residential real estate crisis and should fix it, and if they don’t, the city will take matters into its own hands.
But the current owners of these mortgage loans aren’t banks. They are pension funds and insurers.
The main source of contention here is not constitutionality really, but the fact that a majority of the mortgage loans in question are current. That is, despite the fact that borrowers have been under water, they continue to make their loan payments.
Richmond, along with Mortgage Resolution Partners (MRP), the main proponent of the proposal, argues that underwater mortgages are most at risk of default and hence writing down principal and refinancing these loans is the best way to prevent foreclosures.
But these are borrowers who have been under water for five years. Investors argue there is nothing to suggest that they will start defaulting now when the economy is improving and property prices are rising. Home prices in Richmond have risen more than 20% over the past year, according to Zillow.
Mortgage analysts point out that about 40% of the 624 loans that Richmond plans to buy or seize have already received a modification. The Wall Street Journal reports that at least three loans have a mortgage balance of over $880,000 suggesting that these homes were likely million-dollar homes at the market peak.
"The loans were appraised by an independent, third party valuation expert, whose appraisal takes into consideration the likelihood of default and the loss given default," said John Vlahopolus, a founder of MRP, in an email to TheStreet. "The appraisal of the fair values of the loans reflects these independent judgments. Many of the loans have received modifications, and the independent appraisal takes those modifications into account. Modifications like these have shown a high likelihood to re-default because they still leave the homeowner deeply underwater."
But even if Richmond successfully argues that there is a public benefit in seizing these mortgage loans — courts have over time interpreted the definition of public use fairly loosely — they will still likely fight a prolonged legal battle with investors over compensation.
Eminent domain allows the state to seize private property for public use for a "reasonable compensation" or fair market value, determined by court.
Richmond and MRP say fair market value of a mortgage loan that is worth, say, $300,000 on a home currently worth say, $200,000, is actually just $160,000. The discount to the property value, they argue, is necessary because of the chance of default. Essentially, they are expecting investors in this example to swallow a loss of nearly 50% on a current mortgage.
But the value of a current mortgage loan, investors argue, is not based on the value of the underlying collateral. It is based on the present value of future cash flows.
What’s more, the city plans to refinance the mortgage loan in the example at $190,000, giving borrowers $10,000 worth of equity in the deal. The spread would help pay the city’s costs and MRP’s fees, with enough left to give the new investors in the refinanced mortgages a tidy profit.
But the very fact that these mortgages can be refinanced at a higher rate suggests that Richmond is not buying at fair market value, because investors buying these loans should not be able to make a profit on purchase.
The economics of the proposal for Richmond hinges on the borrowers being current, as investors will clearly not refinance a loan to a borrower who has defaulted. It also crucially depends upon the mortgage loan being bought at a steep discount for it to be profitable to investors.
"There are a lot of assumptions in this plan that just won’t work," says Edward Burg, partner at law firm Manatt, Phelps & Phillips. Burg regularly represents property owners in eminent domain cases in California. "They are taking way too much risk for too few benefits. This is an uncertain area."
Burg says the proponents of the plan ignore the fact that most borrowers who are under water on their mortgage continue to pay their loans because they simply have to. They need housing and rents are rising sharply. Walking away from a mortgage is easier said than done.
Also, he argues, the economic proposal won’t work if the compensation turns out to be higher than what is proposed on the plan. "Broadly speaking, the jury tends to trend closer to the property owner. In the larger cases that I have tried, the property owner got 70% of the spread [difference between the values estimated by the owner and the government]. When the idea of what the mortgage is worth is so far apart, even if they split the difference, [Richmond and its investors] won’t make money."
The city is also underestimating the legal fees they could end up paying. According to Burg, MRP estimates $1,950 in legal fees per eminent domain case. This is ridiculously low, considering the average eminent domain case in today’s underfunded Californian courts is two years, with an appeal adding another two years to the timetable.
There is no provision that stops borrowers from making payments during that time, which means borrowers don’t really get help in this time period.
And if the city decides to abandon the case, it is responsible for the lender’s attorney fees.
Burg cites an example of the city of Oakland, Calif trying to acquire the Oakland Raiders professional football team when it was decided to move the franchise to Los Angeles. The city lost and ended up paying $3.2 million in legal fees to the Raiders’ attorneys. It also entered into a $4 million settlement with the football team which had demanded $26 million in damages because the city had blocked its move to L.A. and deprived it of revenue.
Add to this the very real threat that banks could curtail credit to Richmond and you see how the risks add up. The proponents of the proposal say this is an empty threat, because banks will be violating fair lending rules.
But actually investors in mortgage-backed securities take into account state foreclosure laws and other rules that increase the cost of lending all the time. Fannie and Freddie for instance have proposed raising guarantee fees in states that have an unduly long judicial foreclosure process.
If investors believe there is a risk that a city would seize mortgage loans because the borrowers are under water, they have the right to shun loans originated in those communities. And poor demand from the secondary market will have the effect of curtailing credit in these areas.
At best, the proposal smacks of desperation, as Richmond officials are trying to find ways to revive housing and the local economy.
"The government, encouraged by a private entity[MRP], is trying to solve this problem. But this isn’t the way it can solve it," says Burg.
This article was republished with permission from TheStreet.