Today, I want to talk briefly about whether the plan makes sense -- and whether it would work. To assist those who don't want to spend much more time on this issue, I'll start with the bottom line: I think this is a bad idea and that it will not accomplish its intended goal. I also think the plan carries some potentially harmful baggage.
So why do I think the plan will fail? Pretty simple, really. The entire premise behind the plan is to acquire loans at less than their face, or "par", value (indeed, at less than the value of the underlying home) so that the loans can be rewritten at a lower amount and sold back into the marketplace. The idea seems pretty easy.
Take, for example, a $600,000 loan on a house worth only $500,000. If someone were trying to finance that $500,000 home, they might receive a loan of only about $400,000 -- 80% of the home's value. The idea behind the underwater mortgage plan is to buy the $600,000 mortgage for around $400,000 (or whatever one might realistically expect to borrow on a $500,000 home), to then write a new loan for that same amount (actually, something higher than that amount), and sell it. The homeowner gets a new loan at a "correct" loan balance, and the government is not out any money because the acquisition costs for the eminent domain action are offset by the proceeds of the newly sold loan.
In fact, the plan contemplates having a private funding group, facilitated by the plan's proponent, Mortgage Resolution Partners, take the actual financial risk of the transaction, funding the acquisitions in the hopes of receiving money to repay that investment when the deal closes. For performing this service, MRP will take a set fee ($4,500 per loan).
But in a telling revelation of the plan's real purpose, MRP claims that the investors who fund the plan will earn between 20 and 30 percent on the investment. In other words, MRP claims that even after taking into account transactional costs -- including MRP's $4,500 and all costs of the eminent domain proceeding, including attorneys' fees -- the investors will still spend substantially less acquiring the loans than they will receive when they sell them. To accomplish this, the acquisition price in the eminent domain proceeding will need to be at far less than the home's fair market value.
But what happens if the jury doesn't buy the argument that the $600,000 loan possesses a fair market value of only $400,000. Remember, under California law the owner -- in this case, the lender which holds the underwater mortgage -- is entitled to compensation at full fair market value, defined as being the "highest" price a willing buyer would pay to a willing seller.
To understand how this plays out, we must turn back to something I mentioned in the first post: the plan contemplates condemning only performing loans. In other words, these are loans for which the lender is receiving monthly payments based on the full outstanding loan balance. Moreover, given how far we have progressed in this downward economic cycle, many of these borrowers may have been making timely payments on these loans for several years, despite being under water on the homes.
Add to this the fact that current mortgage rates are historically low. Everyone with a loan that can be refinanced likely has refinanced by now. But what about the borrowers holding underwater loans? Those loans are especially difficult to refinance, despite the fact that many (maybe most at this point) possess interest rates well above a current market rate.
Add all of this together, and what do we have? Lenders will claim that these loans are quite valuable. Specifically, they will likely claim that the loans are worth every penny of the outstanding loan balance. In fact, some have argued that these loans may in some cases be worth even MORE than their outstanding loan balance. In a July 11, 2012, post titled Why the eminent-domain plan doesn’t hurt second liens, Reuters financial blogger Felix Salmon argues:
[W]hen performing underwater mortgages are traded, they’re often sold above par, since the homeowner is locked in to higher-than-prevailing mortgage rates.
In fact, back in September 2011, Mr. Solomon stated that these types of loans were trading in the marketplace at 106 percent of their par value.
If Mr. Solomon is correct, the plan faces a huge problem. Now, that $600,000, "underwater" mortgage may be valued in the eminent domain action at $636,000. Now what? Does the condemning agency still rewrite the loan at $400,000 and sell it back into the marketplace at that amount? Does the agency abandon the taking, subjecting itself to an award of attorneys' fees and costs? And if the agency does go through with the plan, who pays the $236,000 shortfall? Presumably, the shortfall comes out of the pockets of the investors, who now have a huge loss, as opposed to the 20-30% profits they expected.
Sure, these are just made up, hypothetical numbers. But it's easy to see how these eminent domain actions could quickly go wrong if the juries do not agree with the basic premise that the "fair market value" of these loans is something less than the "fair market value" of the houses to which they apply.
There's one other concern that is worth flagging. Let's assume for a moment that the plan works, and that the lenders have large numbers of performing loans taken from them at far less than their par value. Do we really think there would be no consequences in the marketplace?
What is that lender going to do the next time someone in that same community wants a home loan? My guess is that one of two things will happen. Either the lenders will stop lending in markets where they know their loans are subject to being condemned, or they will change the terms on which they are willing to lend. This could include charging higher interest rates and/or loaning to a lower maximum loan-to-value ratio in order to help ensure that the loans do not end up being underwater and subject to condemnation.
In the end, I like the creativity of the idea. I think the stated purpose is a noble one (if one leaves aside the obvious profit motive). But I think the plan will end up mired in considerable litigation. Assuming it survives the legal fights, I think the economics will not work the way the plan's proponents anticipate. Finally, I believe that there will be unintended consequences that harm the overall housing market in those communities that proceed with the plan.
I'm sure there are many out there who aren't too concerned about this plan, since most reports have focused on one particular county in one particular state (San Bernardino County in California -- which, parenthetically, has not agreed to proceed with the plan, despite some reports to the contrary). For those people, I note a July 27 story in MortgageOrg, California's Eminent Domain Advocates Take Plan To New York, which explains that MRP is also shopping the plan in New York. Other reports make clear that MRP hopes the plan will catch on nationwide.
One final note. While Professor Gideon Kanner and I have sparred on issues in the past, his recent posts on this subject reveal that he shares many of the views I've expressed in this series. And if two people who do not see eye to eye on so many eminent domain issues reach the same set of conclusions about this one, I submit there's a pretty good chance we're right.
Might I be proven wrong? Sure. And if someone implements the plan successfully, I'll be right here writing about it and admitting my error. For now, I'm not holding my breath.
P.S. OK, I have to confess that when I started this series, I claimed I was not setting out to advocate for or against the plan. However, as I've read more about it and thought through its implications, I cannot help but conclude that the idea, as explained to date, makes little sense, which explains the tone of this post.