Why using eminent domain for liens is a bad idea

By Felix Salmon
June 21, 2012
Matt Goldstein and Jenn Ablan had an intriguing story: Mortgage Resolution Partners, a politically well-connected firm in San Francisco, was shopping to municipalities the idea of using eminent domain to restructure mortgages.

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A couple of weeks ago, Matt Goldstein and Jenn Ablan had an intriguing story: Mortgage Resolution Partners, a politically well-connected firm in San Francisco, was shopping to municipalities the idea of using eminent domain to restructure mortgages. Then, on Tuesday, Cornell University’s Robert Hockett weighed in, saying that the idea was a compelling one. “To solve a collective action problem, we need a collective agent,” he wrote. “That’s what governments are.”

According to Imran Ghori of the Press-Enterprise in San Bernadino, where the idea seems to be furthest along, Hockett “has been working with Mortgage Resolution Partners” but “said he has no financial interest in the proposal”. I don’t really know what that means, but I think it’s fair to assume that if this happens, Hockett is very well placed to make a lot of money from it. So it’s worth approaching the idea with a skeptical eye.

In principle, I think I can like this idea. On Monday I met with Jorge Newbery of American Homeowner Preservation, whom I’ve written about a few times in the past; his company buys pools of defaulted underwater mortgages from banks, often for just $1 each, and then, having bought the mortgages at massive discounts to par value, can come up with any number of ways to successfully modify the mortgage, nearly all of which involve principal reduction. This is a very successful outcome for nearly everybody involved, but there’s a problem: while Newbery can buy pools of bank-owned mortgages, he can’t buy mortgages which have been securitized. And those mortgages represent the vast majority of defaulted subprime debt.

Newbery started buying pools of mortgages when his original idea didn’t work. That idea was elegant: investors would buy a house in a short sale at the market price, and then lease the home back to the homeowner until the homeowner had the ability to get a mortgage and buy it back at a pre-set price. The idea might have been elegant, but it didn’t work in practice, because the banks wouldn’t play ball: they (and Freddie Mac) simply hated the idea of a homeowner being able to stay in their house after a short sale, and often asked for an affidavit from the buyer saying that the former owner would certainly be kicked out.

The idea from Mortgage Resolution Partners and Robert Hockett basically does an end-run around the banks’ objections: they can’t object to the short sale, because they’re being forced to do the short sale. Clever.

But then things become extremely murky. Here’s Hockett:

Using their traditional eminent domain authority, municipalities can “take” – it’s a constitutional term of art – underwater mortgages from holders for fair market value. They can then write down the loans to just under the values of underlying homes, bringing these back above water. They can finance these takings with moneys supplied by investors, who then are repaid on the refinanced mortgages.

Got that? Me neither. Here’s Goldstein and Ablan, trying to explain the same idea:

Mortgage Resolution Partners would work with local governments to find institutional investors willing to provide tens of billions of dollars to finance the condemnation process to avoid using taxpayer dollars to acquire millions of distressed mortgages.

A local government entity takes title to the loans and pays the original mortgage owner the fair value with the money provided by institutional investors.

Mortgage Resolution Partners works to restructure the loans, enabling stressed homeowners to reduce their monthly mortgage payments. The restructured loans could then be sold to hedge funds, pension funds and other institutional investors with the proceeds paying back the outside financiers.

The key here — which is spelled out in much more detail in Hockett’s 56-page paper on the idea — is that the eminent domain powers are not being used to buy the actual houses in a short sale, as would have been the case under the original AHP scheme. Instead, they’re being used to buy the mortgage. Hockett doesn’t spend any time in his paper or his op-ed explaining why eminent domain should be used to buy mortgages rather than houses, and it’s here, I think, that his plan moves from something which could be a very good idea, to being something which is actually a pretty bad idea.

Here’s how a scheme like this should work. MRP, or a company like it, borrows short-dated money for a term of say three months at very low interest rates. Meanwhile, underwater homeowners in San Bernadino are invited to volunteer for the scheme. Once the money has been raised, it is used to buy those homeowners’ houses at the market rate. The homeowners then buy their houses back from MRP at say a 2% premium to the price paid, using a mortgage given to them either by MRP itself or by some other lender. MRP then repays the short-term loan. MRP’s profits come from that 2% premium, and from its separate mortgage-lending arm; if it wants, it can restrict the houses it buys to only the ones owned by people it would be willing to lend money to.

Under this scheme, the banks or investors who hold the mortgage would receive in return the fair market value of the home in question, just as they would in a short sale. That’s a very reasonable amount to receive for an underwater mortgage, so the banks can’t really complain. MRP would make a modest amount as a middleman and facilitator, and the homeowner would end up with a house mortgaged at its fair market value, rather than at some inflated old purchase price.

But that’s not what Hockett is proposing. Instead, Hockett wants MRP to be able to buy the mortgage, rather than the house. That’s very weird: while it might be legal under eminent-domain law (I have no idea about that), the spirit of the law is very much that the government can buy property, rather than liens. But after talking to Newbery, I understand what MRP is thinking here. His company, AHP, is buying up underwater mortgages for much less than the value of the underlying property — sometimes only 10% or so, and never more than about 25%. Admittedly, all of those mortgages have been in default for some time. But MRP clearly wants to be able to buy mortgages at a deep discount to the value of the home, and then “restructure” the mortgage so that the principal amount is very close to the value of the home. The result could be massive profits for MRP.

In both cases, the homeowner essentially ends up refinancing into a new mortgage with a principal amount just below the value of the home. But in the first case that money is essentially used to pay off the old mortgage holder, while in the second case — the one MRP is proposing — the money goes largely to MRP, the middleman, doing a job only really worth a percentage point or two of the deal.

What’s more, the market for liens is much more opaque than the market for houses, and as such MRP could probably make a colorable case that fair value for the mortgages it wanted to buy was extremely low. Since MRP would have all the important political relationships, the owners of the mortgage — especially if they’re just distant bondholders somewhere — would have very little ability to contest the valuation, and might end up getting paid much less than a genuinely reasonable price for it.

It seems to me that MRP is not adding a huge amount of value here — certainly nothing commensurate with the amount of money it’s likely to make. The real value is added by the use of eminent domain to buy the liens, and it’s the municipal government, rather than MRP, which has that power. So if anybody makes money from using eminent domain, it should be taxpayers: not some private-sector middleman.

If I represented the municipality of San Bernadino, I would respond to MRP’s proposal by giving them two choices. Either cut the city in to a very large proportion of MRP’s profits on these deals, or else force MRP to buy houses rather than liens. Both of those options seem fair to me. Hockett’s scheme, as it stands, doesn’t.

Update: I just had a long conversation with Steven Gluckstern, the chairman of Mortgage Resolution Partners. He explained that they were only interested in buying mortgages held by private-label securitizations, and not mortgages held by banks or by Frannie. Banks would put up too much of a fight in front of the judge, saying that their liens are worth more than the value of the house, even as MRP will never pay more for a mortgage than the house is worth. And Frannie-backed mortgages, of course, are worth par, because of that government guarantee. That alone seemed to me to be an excellent reason to buy homes rather than mortgages — but Gluckstern was adamant that transferring title was far too much work. He also admitted that it might be hard to make this scheme work at all in recourse states: it definitely works best in non-recourse states like California.

The financing for the scheme will come from investors putting up relatively short-term funds: the idea is very much that the homeowner will refinance their mortgage once they’re told they can do so at a much lower face value. MRP is only interested in buying underwater houses where the owner is current on their mortgage, partly because those owners shouldn’t find it too difficult to find a new mortgage for a lower amount. But still, owners in default, or owners whose mortgages are owned by the wrong kinds of institutions, won’t be eligible at all.

As for Hockett, he was paid an honorarium by MRP to write his paper; Gluckstern described him as a consultant to MRP, but definitely not one of MRP’s lawyers. MRP did not see the paper before Hockett published it, but seeing as how Hockett wrote “The Way Forward” with Dan Alpert, one of the key principals behind MRP’s scheme, there was surely no doubt about what his conclusions would be. The disclaimer in Hockett’s paper says only that “Readers should also be advised that the author is disinterested in what he is here recommending, but may subsequently undertake more legal, financial or expository work in connection with the proposals offered and advocated herein.”

Comments
16 comments so far

“That’s a very reasonable amount to receive for an underwater mortgage, so the banks can’t really complain.”

“Fair market value”? If the loans are not already in default, and the house is not too seriously underwater (perhaps less than 20%?), then the banks might reasonably expect more than this.

And my limited experience with “eminent domain” suggests that the process can be fraught with expensive litigation.

My guess is that the banks absolutely WOULD complain, working to milk the system for every penny.

Posted by TFF | Report as abusive

Great points all TFF and I suppose I’m trying to understand why the government might need someone like MRP if this this the route they want to go down. By which I mean, obviously the US government isn’t in it to make money but would in effect be leaving plenty of money on the table for profiteers like MRP.

If using eminent domain is indeed the route to force banks and Freddie Mac to behave in the way the government does, why not hire “somebody” to simply charge a management fee to oversee this program.

Not to mention this would bring out further all the GOP cranks who talk about government forcing the hand of the free market if the government is see as favouring one party (MRP) over another (banks).

Posted by GregHao | Report as abusive

Eminent domain is just another form of the process of foreclosure. In the former government compels the sale; in the latter it’s banks that do that. In both cases, the securing property is sold at the same price – FMV, and all liens erased.

Eminent domain used to buy the liens rather than the securing property – why not? Doesn’t change the FMV of the securing property, does it? And that FMV determines the gross value of the liens. The net value of liens – revealed by their resale prices in that secondary market – reflects a deduction for the costs of executing the foreclosure process, and so is lower than the FMV of the securing property.

In eminent domain the parties litigate over the value of the property. In foreclosure they don’t – an auction determines that value, and except in the most unusual of cases there is nothing at all to litigate. Hard for me to see how eminent domain can be a less costly process.

Hate to keep harping on this, but one must “create a record” – any form of foreclosure/short-sale/debt-relief blows a massive hole in bank balance sheets. Neither our blog-Lord nor the authors of any of the articles can find time or inclination to acknowledge that fact. In moments of weakness I sometimes feel I’m the only person on the planet who can.

Posted by MrRFox | Report as abusive

Putting some example numbers to this situation, let’s say a house with a current fair market value of $150k has a first lien mortgage on it of $200k, so it’s underwater. (For this example, it shouldn’t really matter if that amount is $200k, $180k, $250k, etc. – the point is that the house is underwater.) If that loan is in long-term default, is Felix saying that a bank will sell it to AHP for 10% to 25% of the value of the house, meaning $15k to $37.5k? Or, do I have it backward, and a bank will sell it to AHP for that discount to home value, meaning AHP pays 75% to 90% of the value of the home, or $112.5k to $135k? I can see the latter number making sense based on the cost of foreclosing on a home, maintaining it, and paying a realtor to sell it. The former number doesn’t make sense to me – it seems way too low. I think Felix is saying it’s the higher number, but the statement that AHP often pays only $1 for a defaulted mortgage is confusing me.

Separately, to TFF’s point, I’d say that a modestly underwater mortgage on a home that’s occupied by a creditworthy borrower who is current on payments is quite likely worth more than the FMV of the home, particularly since the interest rate on the mortgage is probably above current rates. My understanding of eminent domain is that the government is required to pay FMV for the specific property being purchased. Since the FMV of an underwater mortgage depends not only on the value of the home but on the creditworthiness of the borrower, I’d think that the government could have to work through that math on each individual mortgage, not just rely on a standardized rule such as paying 100% of FMV for every home. If owners of mortgages chose to dispute values, this process would be a prolonged legal mess.

I’ve not heard of eminent domain being used by governments in the U.S. to purchase loans or securities, as opposed to real property, though it’s been broadly used with real property, including to buy real property from some private owners in order to transfer it to others, which was the subject of the Kelo case a few years ago. I’m dubious that the economics would ultimately work to buy mortgages using eminent domain unless the government is able to use an extremely favorable definition of FMV. There’s substantial administrative costs and downside risk, paying FMV should mean by definition that there’s no windfall profits to the buyer.

Posted by realist50 | Report as abusive

John Hussman has a good proposition:
“Here are the details of my proposal to establish property appreciation rights (“PARs”), which engage the Treasury to coordinate (but not subsidize) the restructuring of mortgage debt:

Suppose a $300,000 mortgage is in foreclosure (or the homeowner and lender can agree to the following arrangement outside of foreclosure court). One possible mortgage restructuring might be to cut the principal of the mortgage to $200,000, and to create a $100,000 PAR. The homeowner would agree to pay off the PAR to the Treasury (and administered through the IRS) out of future price appreciation on the existing home or subsequent property. Ideally, the actual restructuring would involve a PAR obligation of less than $100,000 – possibly half the amount of principal reduction, but some mutually acceptable proportion could likely be negotiated.

The homeowner would be excluded from taking on any home equity loans or executing any “cash out” refinancings until the PAR was satisfied. The maximum PAR obligation accepted by the Treasury would be based on the value of the home and the income of the homeowner. The program would only be available for mortgages restructured to the point that they were no longer underwater. The lender would receive not a direct claim on that homeowner, but a participation in the Treasury’s “PAR fund” which would pay out proportionately out of all PAR proceeds received by the Treasury by homeowners over time.
http://www.hussmanfunds.com/wmc/wmc11060 6.htm

Posted by traian | Report as abusive

@realist, AHP buys liens for 25% of the value of the house, not 75%. Which does sound low. There are two main reasons why the prices are that low. Firstly, these are liens which have often been in default for as long as five years, racking up taxes etc along the way. It’s not easy turning them into cash. Secondly, the value of the houses is normally much lower than $150k; often it’s lower than $10k. AHP specializes in low-value houses, which just aren’t worth the while of servicers to foreclose on.

Posted by FelixSalmon | Report as abusive

@Traian – It’s a shared appreciation deal on the underwater portion of debt, as you describe it. The pooling feature is new, but it doesn’t change the concept from what was touched-on in earlier threads on this. If the appreciation never happens, who eats the loss? What if the owner wants to sell and move – can he? How does the bank carry the item on its books – do they book the loss immediately (would have to under GAAP)?

If I’m the owner, why don’t I just hand the keys to the bank, walk across the street, buy the identical house in foreclosure at FMV (and with attractive financing) and keep 100% of any future appreciation for myself?

Posted by MrRFox | Report as abusive

@Felix – thank you for clarifying. That explanation makes perfect sense. Regarding your 2nd point about home value, it sounds like a classic case where transaction costs (here foreclosure costs) are more or less the same whether the underlying asset (here a home) is worth $10,000 or several hundred thousand dollars, so at a low value the transaction costs almost equal the cost of the asset.

I think that the $150k case – albeit with hefty tax liens in some cases – is closer to what San Bernadino will face if it tries to buy up a large number of mortgage liens in the county. $10k homes, at least in any significant numbers, sounds more like rough parts of Detroit.

Posted by realist50 | Report as abusive

@MrRFox, if you default on your current mortgage, you’ll have trouble getting financing on a new purchase. Might take 7-10 years to restore your credit after that?

Posted by TFF | Report as abusive

@TFF – Good observation. Here’s the solution – I buy the new house before I pay a visit to my old bank, with the keys.

Posted by MrRFox | Report as abusive

@MrRFox – is it really that simple, to just hand the keys in? Also, unless you’re making a ton of money, how will you get approved for mortgage on the house across the street even before you hand in the keys?

Posted by GregHao | Report as abusive

Banks have grown leery of this possibility. If they suspect it is in play, they don’t give you the new mortgage. This can be a real problem for people who hope to keep the old property as a rental and buy a new one.

Posted by TFF | Report as abusive

@GregH, @TFF – we’re talking non-recourse states only here, so – yes, it is that easy; don’t even have to make the trek to the bank – just stop paying. The old, underwater house is never going to put money in your pocket, so ‘selling’ it shouldn’t be a material precondition to anything.

May have to be a little clever/creative/cunning to out-maneuver the banks on the purchase of the new property. Bet I could do it if I had to. If you can’t manage that – rent.

Posted by MrRFox | Report as abusive

I bet you could do it too, MrRFox, but most underwater homeowners don’t have cash for a new 20% downpayment. As usual, the system favors the wealthy and those with liquidity.

Posted by TFF | Report as abusive

Finally a mortgage resolution! It is great to read that some of our fellow citizens have embarked to think outside of the box and our comfort zone. The mention of eminent domain makes everyone squirm, but think it through. Is anyone really in their comfort zone after the banks received trillions of dollars of bailout money with the purpose of lending and reinvigorating our economy in 2008, but never giving back to the taxpayers who bailed them out, to only pay themselves nice bonuses? That is definitely not in my comfort zone. I condemn the banks for their greedy actions at the expense of this nation’s poor and middle class.
The middle and lower class citizens of this country who were economically kicked back 20 years by the 2008 mortgage crisis are the people, parents and their children who deserve consideration now. Not one of them was responsible for the economic crisis, but have paid the price sorely. We are the banking and “investment” industry’s “collateral damage”.
Now a few forward thinking and civilly minded people have thought out of the box and our comfort zone to bring a real solution to the mortgage and economic crisis facing this country. The banks have already taken their losses on real estate (a requirement under GAAP), but they have resisted all attempts to correct their bad bets in the housing market. If this nation is a community, then the politicians in our local communities need to get involved to provide the solution to their neighbors, families and friends. Communities thrive where families have homes. Families maintain them and the entire community benefits. Who wants to see a family put out on the street and the home sitting vacant and dead? Foreclosed homes negatively impact the value of everyone’s home.
Washington is incapable of navigating the housing crisis given the conflicts that bank lobbyists present and the special interests that buy their votes. I don’t like the words “eminent domain and condemnation” but I really dread the words “foreclosure, eviction and homeless”. Mortgage Resolution Partners has thankfully thought outside our comfort zone in order to give comfort to families and the communities in which they live, work, send their children to school to learn and where they attend houses of worship to pray. If we don’t solve the mortgage crisis, our economy will never recover.

Posted by Beebe | Report as abusive

@Beebe – Just because it’s “out-of-the-box” doesn’t mean it’s not a mistake. IMO that MRP thing is. The intention may be good and the need acute, but half-thought-out ideas don’t solve IRL problems. And about the intention -

IMO getting mixed-up in anything that includes Phil Angelides as a sponsor is dumber than lending $200k for a music school romp. Both got “fatal outcome” written all over them.

Needs more thought.

Posted by MrRFox | Report as abusive
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