Richmond, California’s use of eminent domain continues to move forward. As regular readers know, the entire plan is a fraud intended to rip off investors so that Mortgage Resolution Partner (MRP), the firm supplying the capital to Richmond, can profit. Why Richmond agreed to take MRP up on it’s ridiculous plan has been unknown for a while now. Maybe they really don’t understand it. Maybe there is corruption involved. It’s unclear.
What is clear though is that the ultimate losers from this play will be Richmond residents. Investors are (rightfully) infuriated by Richmond’s decision to move forward with eminent domain and have filed a lawsuit attempting to block the plan. A judge threw out that suit, saying it was “premature,” but the legal battles are just beginning. Once the city does seize the mortgages, investors will file suit again. Hopefully a judge immediately sees through this highway robbery and isn’t fooled as well. This entire thing is an unnecessary and costly waste of time.
In the end though, investors will be okay here. MRP’s plan will fail. The losers will be Richmond residents, which Moody’s made clear last Friday. The credit rating agency named the plan “credit negative.” From the report:
The eminent domain program is credit negative for the city because it will likely lead banks to raise mortgage interest rates and reduce mortgage availability, which will in turn limit the growth of property values and related taxes
Lenders will factor in the additional risk by raising mortgage interest rates or decreasing their availability
None of this is surprising, but it’s still sad to hear.
If this plan was done properly, Richmond would offer up a fair value to investors. Some of those investors may disagree with Richmond’s valuation. There would be quibbling and the two sides could look to work out a fair deal. Some banks may be wary of the additional risk and factor it into higher rates, but the rise would be small. If investors are properly compensated, they won’t be too upset to offload defaulted, underwater mortgages. They may not even put up much of a fight. In the end, mortgage rates wouldn’t rise much, if at all. But MRP’s plan is such a ripoff that if it were to go through, banks would jack up rates. Luckily that won’t happen, but it shows what a mess this entire situation is. MRP’s plan is a fraud, Richmond fell for it and its residents pay the price.
Not much has happened in the past couple of weeks with Richmond, California’s use of eminent domain to help underwater borrowers. As I’ve said a couple of times, this is just a big scam by the firm supplying the capital, Mortgage Resolution Partners (MRP), and Richmond fell for it. It’s come out recently that the borrowers of the mortgages MRP is looking to seize are current on their payments. Banks and investors, not surprisingly, have no interest in giving these up and have filed a lawsuit to stop the plan. MRP pushed back with a ridiculous argument:
[MRP Chief Strategy Officer John] Vlahoplus, of Mortgage Resolution Partners, disputed the analysis, saying he’s confident that all of the 624 borrowers are indeed underwater. The city’s appraisals of the properties, he said, were handled by a firm whose work has been highly rated by securities trade groups.
About two-thirds of the borrowers have indeed stayed current on their loans, he said. But helping them now — before they default — is the best way to make sure they stay current on the loans and thereby limit further damage to Richmond’s battered neighborhoods.
“The intent here is to help the neighbors,” he said.
This is absurd. All of these mortgages were created before 2008, meaning that two-thirds of these borrowers have weathered the Great Recession and are still making on-time payments. These are performing loans. Investors love them. And now MRP is coming in and seizing them at well-below fair value to prevent them from defaulting in the future. After the economic disaster of the past six years, what are the odds that now these homeowners are going to default with the economy improving? Very low. And MRP is doing all of this is to help the neighbors!
Give me a break. The brashness of this argument is truly astounding. I have no idea how Richmond fell for it and I can’t imagine that any judge will as well. And it still overshadows the fact that eminent domain really could be a powerful tool to help underwater borrowers. What a shame.
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:
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. .
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 .
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.
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.