New Plan To Bail Out Underwater Mortgages Has Banks Panicked
Earlier this month, Mayor Gayle McLaughlin of Richmond, Calif., along with a band of activists and homeowners, arrived at downtown San Francisco with a singular purpose: to convince the CEO of Wells Fargo to drop a lawsuit against the city of Richmond.
A city of about 100,000, Richmond finds its economic recovery efforts stymied by a continuing housing crisis that sees a glut of underwater mortgages — mortgages where the balance due on the loan grossly exceeds the fair market value of the property. This is creating a swollen rate of defaults, as many borrowers cannot afford repayment plans and others “strategically default” on their mortgage, knowingly surrendering their home to banks when it’s no longer worth paying back the loan.
This is leading to a large swathes of abandoned homes, blighting the landscape and depriving the city of tax revenue.
McLaughlin’s plan to remedy this problem is one that Seattle, Newark, North Las Vegas and El Monte, Calif., are also considering: using eminent domain to purchase underwater mortgages from the banks before renegotiating them at fair market value to help the lower- and middle-classes emerge from the Great Recession.
Some of the major banks, as well as the Federal Housing Finance Agency, are unhappy with this plan. Wells Fargo and Deutsche Bank are suing Richmond and Mortgage Resolution Partners — the San Francisco-based investment firm Richmond has contracted to implement the city’s plan — on the basis that successful implementation of the plan would encourage other communities to do the same. That, they say, theoretically could collapse the mortgage industry and trigger another recession.
“I am absolutely not backing down,” McLaughlin said outside the Wells Fargo building in San Francisco after the bank locked the mayor’s demonstration out of the building. “Nothing has been done for the last five years or more. A fix is needed.”
The banks, however, disagree. “Mortgage Resolution Partners is threatening to seriously harm average Americans, including public pension members, other retirees and individual savers through a brazen scheme to abuse government powers for its own profit,” said John Ertman, a partner at Ropes & Gray LLP, the firm suing the city on behalf of banks’ investors. “This unconstitutional application of eminent domain will be devastating for mortgage finance both public and private. It will completely undermine the willingness for private capital to return to the mortgage markets.”
“No investor in any trust will be made worse off by the sale of any loan,” fired back Steven Gluckstern, chairman of MRP. “Rather, it is these trustees that are wasting trust assets at the expense of America’s pensioners by pursuing fruitless litigation.”
A controversial plan
In a statement issued after the lockout, Wells Fargo said in a statement:
“Wells Fargo, in its role as either servicer or as trustee, does not have the contractual authority to sell the loans that the city of Richmond has sought to purchase and believes the threatened use of the power of eminent domain to acquire the loans raises significant and troubling constitutional and other issues.”
“Wells Fargo’s commitment to responsible lending and our work to help customers facing payment challenges, has resulted in a foreclosure rate of less than 1 percent of owner‐occupied loans in our servicing portfolio over the past year,” the bank said. “Wells Fargo has helped more than 870,000 customers with loan modifications and has extended more than $7 billion in principal forgiveness since January 2009.”
Richmond’s plan is based on a position paper published by the Federal Reserve Bank of New York in June. In “Paying Paul and Robbing No One: An Eminent Domain Solution for Underwater Mortgage Debt,” author Robert Hockett argues that the key to relief from underwater debt is government intervention. By utilizing eminent domain, municipal and state governments could bypass problems found in pooling and servicing large numbers of mortgage refinancing requests and effectively lower the principal on the borrowed assets — reducing the risk of default.
“While home prices — and hence home equity values — have fallen and remain low, the fixed debt obligations that buyers had to take on to purchase homes under bubble conditions have not,” the report reads. “Consequently, approximately 11 million homes, or slightly less than a quarter of all homes with mortgages outstanding, are ‘underwater’ — meaning that the balance on the mortgage exceeds the current market value of the home. Of these mortgages, between 3 million and 4 million are in default, in foreclosure, or foreclosed and awaiting liquidation. Over 2 million more are seriously delinquent — two-to-four payments in arrears.”
Here’s how the plan works: First, the city makes an offer to purchase the underwater mortgage from the bank at half the principal. So for a $300,000 mortgage on a property worth $200,000, the city offers the bank $150,000. Then, the city offers a new mortgage to the property owner at or slightly beneath the property’s fair market value. In the current example, that might be $190,000. If the bank refuses, the city seizes the property under eminent domain and offers “fair compensation” under the fair market value.
MRP would get $4,500 per completed sale and would share any additional profit with the city.
Eminent domain and bank losses
“Eminent domain” is a remnant of British common law that recognizes that land ultimately belongs to the state. As this principle has been applied in the United States, the sovereignty of the individual influenced, but did not eliminate, the government’s domain of its territories. The Bill of Rights directly addressed issues of “eminent domain”: the Third Amendment forbids the forced quartering of soldiers in a private home — which courts variously have interpreted as protecting the “sanctity of the home” from government intrusion — and the Fifth Amendment prevents the government from seizing real property without “fair compensation” to the owner.
The 1954 U.S. Supreme Court case Berman v. Parker determined that property can be seized by the government — even if the property will ultimately end up in private hands — if the result of the seizure can clearly be argued as a public use, such as removal of urban blight or the creation of new roads. With 2005’s Kelo v. City of New London case, the requirements for eminent domain were loosened to allow any project that serves the “public benefit” — including job creation, increased tax revenues and removal of condemned properties.
One of the problems of eminent domain is that the constitutional requirement for “fair compensation” is weakly defined and includes anything that can be successfully argued in a court of law. In practice, this has meant compensation at pennies to the dollar for the property owner, constituting a forced loss.
To demonstrate this, let’s assume the previous example of a $200,000 house with a mortgage of $300,000. Let’s assume that the property was mortgaged just before the Great Recession in August, 2007. At that time, the average 15-year rate for mortgages was 6.22 percent. So, the value of a mortgage for a home currently valued $200,000, under a 15-years mortgage is nearly $1.3 million.
The bank would have received nearly $1 million in profit on the $300,000 it originally lent. Should the bank accept the city’s offer of $150,000, the bank would calculate its losses as around $1.1 million for this one property alone. Multiply this by the 600 offers Richmond has sent out thus far and it’s obvious why the banks hate this idea.
Fair market value is based on assessments made at the time of offer. If the negotiated property sits in a community of defaulted properties, if the property owner failed to maintain the property or if the demographics of the community change, the fair market value would have dropped, too. Most mortgages go “underwater” because of a shift in the fair market value. If the banks are forced to take the property at fair market value, it could be radically less than the value it based the loan on. Assuming a fair market value of $200,000, the bank losses over $1 million over the life of the loan.
This is, of course, only one way to look at it. From the homeowner’s point of view, a new mortgage, negotiated at $190,000 at 15-years at today’s rate of 3.76 percent would drop the total lifetime cost of the mortgage to about $450,000. This would mean savings upwards of $800,000.
While this wouldn’t exactly amount to ‘immediate’ relief to underwater mortgage borrowers, the financial loss to the mortgage industry would be immediate in its devastation. But the threat of this alone may be enough to solicit change, forcing recalcitrant pension funds, banks and other financial institutions to the negotiating table. It will also put lenders on notice in other cities willing to use this strategy.
As Tim Cameron, a lobbyist with the Securities Industry and Financial Markets Association, puts it, “There’s a domino effect in play here.”
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