Cities Grabbing Houses Won't Fix the Market
Mortgage principal reductions are one of those policy ideas that never dies, or goes anywhere. The theory is simple enough: One of the biggest predictors of default is being underwater -- the value of the house being less than the mortgage -- so if you do a principal reduction, you lower the risk of default. You also prevent some related problems, including people who can’t move to take a better job because they’re underwater on their mortgages. All else equal, that should goose the economic growth rate a bit, especially now, when unemployment is so high.
The politics are equally simple: You take money from bankers and bond investors, who are relatively small in number, and give it to homeowners, who are many. It’s electoral gold for a politician who can pull it off.
Why hasn’t it happened, then? A few reasons. For one thing, while direct bond investors are rare, indirect investors, such as pensioners and bond mutual fund owners, are fairly common. And there is another large group of people who will be affected by this: potential homeowners. Making banks eat the losses when the market falls, while letting homeowners enjoy the upside, is a swell transfer from banks and investors to homeowners. But of course, banks and investors don’t like having the government take their money and give it to homeowners. They tend to respond to this sort of thing by refusing to make loans, or requiring higher rates on the loans that they do make.
Now, this sort of thing can be exaggerated -- financiers frequently threaten that a sovereign default will result in the termination of all financing for that government, forever, only to come back in a few years when memories have dimmed. On the other hand, the advocates of sticking it to the banks are usually entirely too sanguine about what will happen to financing costs afterward. Investors said that Argentina would make itself a pariah on global capital markets by demanding very deep haircuts for owners of its bonds in the early 2000s. Argentina went ahead and demanded the haircuts, and now it remains a pariah on global capital markets. That has created all sorts of internal problems, and forced the government to resort to increasingly dubious financing mechanisms, such as nationalizing its private pension system. Forced principal write-downs would certainly have made the U.S. mortgage market even less attractive than it already was in 2009.
But that’s not even the biggest reason the government avoided reductions. The biggest reason is that forcing banks to give a bunch of money to homeowners by writing down their loan to the value of the collateral would probably have been a "regulatory taking," according to the experts I consulted, which means that the government would have had to pay for it. Something that sounded all awesome and social-justice-y when it was banks and rich investors paying for it starts to sound like an expensive giveaway when it’s going to be added to your tax bill.
So the idea never went anywhere at the federal level. But it never really went away, either. Now a company called Mortgage Resolution Partners has been trying to interest local governments in a plan that uses their eminent domain powers. The theory is that you seize the mortgages out of privately backed mortgage bonds (they seem to be wisely steering clear of mortgages owned by Fannie Mae and Freddie Mac, on the completely correct theory that Congress will intervene to stop them if they try to hang Uncle Sam with the check), pay the banks the diminished value of the collateral, then sell the homes back to the owners at a markup. The city gets a cut to cover its costs. So, naturally, does MRP.
Why are they trying to seize the mortgages and not the houses? Presumably, to avoid trashing the homeowner’s credit. If you seize the houses, and the homeowner gives the bank whatever pittance they've been paid, that goes down on their credit as a big black mark for not staying current on their loan. Seize the mortgage and perhaps you can do this deal without sending everyone’s FICO score into the 500s. It’s an interesting plan, but it’s somewhat risky; as far as I’ve been able to ascertain, no one’s ever used eminent domain to take a mortgage instead of a house.
San Bernadino, California, considered signing up with MRP, then backed out after officials thought about the potential consequences for the local housing market. Now Richmond, California, is moving forward. It has sent letters to the holders of more than 600 underwater mortgages, demanding to buy them at a steep discount. If the city doesn't get a voluntary sale, it is threatening to take them via eminent domain. Most of these are performing loans, which is to say that the borrowers are still making the payments. The bondholders are going to take a substantial loss on those homes, which the city says it will buy for between 25 percent and 100 percent of the face value of the mortgage.
I think that Richmond officials are probably going to end up regretting this decision, if they do indeed take it all the way. The mortgage holders probably aren’t going to turn over the mortgages voluntarily -- one of the experts that my Bloomberg News colleagues spoke with there wasn't even a legal way to sell performing mortgage out of these pools -- which means that the city is going to end up in court -- 624 times. That’s probably going to be lengthy and expensive, even if it wins.
And it could lose. Remember, the city is not seizing houses, which can have fairly well established market values; it is seizing performing mortgages, and claiming that the fair market value of the mortgage is the value of the underlying collateral. But, of course, the payment stream on a performing underwater loan is worth far more than the value of the collateral; not only are these loans for more than the value of the home, they’re at higher interest rates than current loans. Richmond could seize these homes and then have a judge rule that it must pay the market value of the performing loan, instead of the market value of the house. That would be a very expensive mistake; at best, it backs out of the seizure, and ends up on the hook for substantial legal fees.
And that's not the only way this could go wrong. Republican members of Congress are already proposing rules to prevent federal housing programs from backing mortgages on any properties seized by eminent domain this way, and the Federal Housing Finance Agency’s chief counsel has expressed some doubt as to whether the seizures are legal. If the federal government won’t issue new mortgages for the property at written-down values, then the City of Richmond will either have to finance the mortgages out of city funds, or . . . actually, I don’t know what “or” is; the federal government now dominates the mortgage market so thoroughly that it’s hard to think of a plan B. While home prices don’t seem to be excessively high in Richmond, financing 600 homes at even $150,000 apiece would require the city to come up with $90 million. Its total operating budget is $134 million for 2013.
It would be even worse if homeowners in Richmond have trouble getting mortgages in the future -- something which both the bankers and some Republican lawmakers are considering. Farewell, property taxes. Hello, angry hordes marching on City Hall.
And, even if the plan does go through, and neither courts nor regulators stop city officials, litigation costs will probably have destroyed much of the value they hoped to add to the community. Unless they’re currently paying a squad of lawyers to sit around and do nothing, this seems like a mad plan.
For the city, I mean. On the other hand, for MRP, it’s a great deal. What do its executives care if Richmond homeowners have trouble selling their homes in the future because they can’t get financing? MRP will collect its fees, just the same.