Yes, Eminent Domain’s Use in Richmond, CA is Pure Fraud

Let the lawsuits begin.

I wrote last week about Richmond, CA had been duped by Mortgage Resolution Partners (MRP) into using eminent domain to “help” underwater borrowers refinance their homes through principal reduction. MRP supplied capital to the city so that it could purchase the mortgages from investors. Except MRP refused to pay more than 85% of the value of the home. For borrowers who were current on their mortgages, this was a blatant rip off. The value of those mortgages would likely be worth more than 85% the value of the original loan, significantly more than the value of the home. The question was: Were borrowers who are current on their loan part of Richmond’s plan?

The answer is a resounding yes and now investors have filed suit against the city:

The initiative has targeted mainly the loans of borrowers who are current on their payments, which make up 444 of the initial batch in Richmond, where the city council still hasn’t formally authorized the use of eminent domain. Mayor McLaughlin vowed to take the step on a July 30 call with reporters.

Richmond is going after 624 loans, of which more than 70% are held by borrowers current on their mortgages! This is an absurd rip off for investors, who are claiming they’ll lose $200 million under the plan. I’m not sure if that $200 million figure is right, but investors certainly will lose a huge amount of money. I can’t see how any judge will be fooled into thinking this is the “market value” of the loans. I’m pretty shocked that Richmond fell for MRP’s idea. This is just so blatantly illegal. It’s fraud. Yves Smith has more here, but all you have to know is that MRP is using Richmond to defraud investors and the city will ultimately pay the price.

Eminent Domain Could Be a Powerful Tool in Housing

My post this morning focused on the major flaw in Richmond, California’s plan to use eminent domain for underwater mortgages, but it is always not a bad idea. Eminent domain could have a beneficial use in the housing market.

First, let’s look at a simple housing market. If an underwater borrower falls behind on his payments, the lender (the bank) may decide to either foreclose on the property or to restructure the loan. Foreclosures are costly and time-consuming for banks so sometimes, banks will choose to write down the principal of the loan so that the homeowner becomes back above water and can refinance. The homeowner then makes payments to the bank on his refinanced loan. The bank doesn’t earn as much as it did had the borrower stayed current on the original loan, but it still earns more than if it had gone through with the foreclosure.

But this system becomes a lot more complicated when loans are securitized and sold off to many different investors. This creates a collective action problem. If the government – or any company – wanted to write down the principal of mortgages to bring them back above water, it would have to acquire almost every tranche of the mortgages. If just a few investors refuse to sell, the firm would not own enough of the loans and would be unable to write down the principal. Thus, no company wants to devote its resources to contacting and coordinating with many investors without any guarantee of a payoff at the end. This is a classic collective action problem.

There are also three other small yet important problems that eminent domain solves:

  1. Servicer incentives. Banks normally outsource many aspects of their lending program to servicers as banking activities become more complicated. For instance, servicers collect payments, pay taxes, modify loans and supervise the foreclosure process. Unfortunately, servicers aren’t looking out for homeowner interests – they care about their own bottom line.  This is a problem, because servicers earn the most in fees when borrowers are delinquent or during the foreclosure process. This gives servicers an incentive to not help borrowers become current. It’s also costly for servicers to modify a loan so even if a bank and the borrower both are in favor of principal reduction, the servicer may stand in the way.
    .
  2. Pooling and Servicing Agreements. A further problem is that servicers are limited in how much they can modify loans by pooling and servicing agreements (PSA). Most loans have been securitized and sold off to many investors, but this creates a problem: investors don’t want the servicer to make huge changes to the loan without their approval, but also want to give servicers some flexibility to make minor adjustments. The rules for what servicers can and cannot do are outlined in the PSA that accompanies the mortgage. Most PSAs only allow the servicer to modify up to five percent of the loan without supermajority approval from investors. If servicers want to significantly reduce the principal on the loan, they must spend resources coordinating with numerous investors, without any guarantee that investors will ultimately approve the principal reduction. The high coordination costs offer little reason for servicers to modify the loans
    .
  3. Tranche Warfare. A little known problem with principal reduction is that once the loan is securitized, different investors have different appetite for principal reduction. For instance, investors who own the senior tranches of a loan are most likely to be paid off  and may not want the servicer to modify the loan. The owners of the junior tranches, on the other hand, are less likely to receive payment and have greater incentives to reduce the principal. If the servicer does make significant modifications, it is giving the owners of the junior tranches preferential treatment at the expense of investors in the senior tranches. The servicer is technically supposed to represent the interests of the mortgage owner, but when there are multiple owners and their interests diverge, the servicer is left with few acceptable options. At the extreme, investors in the senior tranche could sue the servicer if it modifies the loan. Thus, many servicers have been hesitant to modify loans for fear of legal action against them, even if the majority of owners of the mortgage would prefer to modify it.

Eminent domain solves all three of these problems. Since the municipality owns all parts of the mortgage, the potential for tranche warfare no longer exists (solving problem No. 3). In addition, the city does not need a servicer and does not have to use a PSA so the limitations of the agreement no longer exist as well (solving problems No.1 and No. 2). Most importantly, the collective action problem associated with high cooperation costs is eliminated as well.

A House in Richmond, CA (Photo: Ed Andersen)
A House in Richmond, CA (Photo: Ed Andersen)

Since the city or company is a single entity, it does not have to worry about wasting resources coordinating between many investors. Instead, eminent domain requires all investors to sell at fair market value, eliminating the risk that a few investors defect and refuse to reduce the principal. Eminent domain solves the collective action problem.

That’s where the value of eminent domain is in the housing market. However, it requires that the government to at least offer a fair market value – something Richmond is not doing. Why is Richmond not doing it? Because the only way Mortgage Resolution Partners (MRP), the firm supplying the capital for the proposal, will profit is by paying below market value. Without those profits, MRP would not be interested in the deal. By itself, Richmond doesn’t have the funds to purchase the loans at fair value. It needs MRP’s financial backing and in return, it’s ripping off the original investors so MRP can profit. That’s why this deal is unconstitutional and will surely fall apart in the courts. But don’t overlook the fact that done correctly, eminent domain can be a powerful tool to overcome the collective action problem in modifying loans. It just wasn’t done correctly here.

Eminent Domain is Coming to Richmond, CA

After quite a bit of searching, Mortgage Resolution Partners (MRP) has finally found a town willing to take a chance on its plan to use eminent domain to help underwater homeowners. The details for this specific plan aren’t quite clear yet, but this plan still has a major problem. Let’s first look at how this will work.

Richmond is giving investors a choice: either willingly sell or we’ll use eminent domain to force you to sell. According to the New York Times, the city is offering to pay what it deems to be fair market value:

The city is offering to buy the loans at what it considers the fair market value. In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default.

MRP’s plan has been to put up the capital for these purchases so that no taxpayer money is involved. After it has purchased the loan – either by agreement or by force – the city will write down the value of the loan so that the homeowner is no longer underwater and can refinance at lower rates:

Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program. The $30,000 difference goes to the city, the investors who put up the money to buy the loan, closing costs and M.R.P. The homeowner would go from owing twice what the home is worth to having $10,000 in equity.

Done correctly, using eminent domain to purchase underwater homes is a promising idea. Unfortunately, MRP’s plan has always been aimed at helping investors make a nice profit, not helping out homeowners. This plan has the same major flaw: it doesn’t just write down loans for homeowners delinquent on their loans, but also for borrowers current on them.

The intellectual godfather of the plan, Cornell professor Robert Hockett, noted in his paper promoting the plan that MRP would only contribute capital to use eminent domain for mortgages that are current. The problem with this is that these are the homeowners who don’t need help. Yes, they are severely underwater and would be helped by a principal write down, but they aren’t defaulting on their loans. They are still able to make their payments.

Of course, for that reason, those borrowers are also the most valuable for investors. Homeowners current on mortgage payments on a $400,000 loan that is for a house worth only $200,000 is still profitable. The security is no longer worth face value since the losses in the case of default are now higher due to the lower home value. But that means the loan is worth somewhere between $200,000 and $400,000, depending on the risk of default. Since the home is worth $200,000 now, the loan is worth more than 100% fair value of the home.

MRP’s original plan was to only use eminent domain for homeowners current on their mortgages and would not pay anything more than 85% the fair market value of the home. As just shown, these loans are worth more than 100% the value of the home. No investor would ever be willing to sell at this price, even if it could solve the collective action problem that permeates the housing market (more on this later today).

However, this is the only way MRP makes money. If it were to purchase the loan for $250,000 (as it may be worth) and then refinance it at $200,000, it would lose money on the transaction. The only reason that the company earns a profit is because it’s using eminent domain to pay significantly less than the fair value of the loan.

Banks are (rightfully) furious at Richmond’s plan and will undoubtedly take this to court, arguing that the proposal is unconstitutional in a number of ways. Not least of all is the fact that eminent domain requires the city to pay fair market value for property. In purchasing the mortgages of homeowners who are current on their loans, Richmond is certainly not adhering to that rule. What really sucks for the city is that banks will likely freeze credit in the area as both a punishment and a deterrent to warn other cities not to follow in Richmond’s footsteps. Maybe more details will emerge that make this plan look like a better deal, but right now it’s looking like MRP finally duped a municipality into implementing its plan and Richmond is going to face severe consequences for doing so.