Condemnation of Underwater Mortgages: Some Feedback and Additional Observations

Over the past few days, I've had several conversations and have received a number of emails concerning the underwater mortgage series I posted recently.  

Rick Friess, one of my former colleagues, commented on the series and provided two additional sources of concern.  Because I suspect many people missed his comment, I'm copying it here:

I agree with your analysis, and I see at least two other reasons this plan will not work. First, many, if not most, of the loans are likely refiances, not purchase-money loans, so the lenders will have recourse against the borrower. Thus, if the lender is shorted in the eminent domain action, to make up the difference the lender can turn around and sue the very homeowner who is purportedly benefiting under this plan. Second, loan documents almost always require the borrower to pay to defend the lender in any eminent domain action, typically with counsel of the lender's choosing. So on the homeowner's dime, the lender can fight hard against the eminent domain action, and the lender has every reason to do so. Any benefit to the homeowner could quickly be wiped out by the homeowner's payment for the lender's attorneys' fees. The homeowner could even end up in a worse position.

I think these are both valid concerns, and I wish I'd thought of them myself.  One could presumably avoid the first problem by condemning only purchase money loans, but that would further restrict the pool of available underwater mortgages that fall within the scope of the plan (the proponent has already omitted all loans that are not performing and all government-backed mortgages held by Freddie Mac and Fannie Mae). 

(For anyone who doesn't know, there is a huge difference between the initial loan made on the purchase of a house -- a so-called "purchase money" loan -- and a refinance.  Under the law, if the borrower defaults on a purchase money loan, the outstanding loan is not recourse to the borrower.  In other words, the lender can foreclose on the property, but cannot pursue the borrower independently for any shortfall.  A refinance, however, is quite different.  If the lender cannot recover the entire balance of the loan, the lender has the ability to sue the borrower directly for the balance.)

The second problem Mr. Friess raises is harder to avoid.  He is right.  Most mortgages issued by large financial institutions contain language that requires the borrower to pay the lender's attorneys' fees in any litigation, including eminent domain.  A lender could use these provisions to punish any borrower who tries to take advantage of the plan.  The attorneys' fees could easily exceed the savings the borrower might realize through the lower loan balance.

In addition, Bill Wade, about whom we have written in the past, wrote me to offer his views on the plan.  He concludes the plan is a bad idea as well, but he comes at things from a somewhat different perspective.  With his permission, here is a copy of the email he sent me:

Rick,

While I am not a banking expert, some commonsense economic issues may bear upon this matter -- regardless of what the law allows.

Forced write-downs of these loans could cripple selected bank reserves. Banks have been trying to increase capital reserves for four years now. Some have not done well in so-called "bank tests." This forced recollateralization likely would be the coup de gras for some small banks. For example, two in my little town currently are being operated by the regulatory agency. Banks like these could fail if they have much exposure. The net result might be that only a few large banks survive and emerge. But, this increases the "too big to fail" unintended consequence.

Now, on to loan portfolios. Assume a large tranche of loans bundled as a AAA bond. If a large percentage of the loans behind the bond were written down, the banks would be forced to continue to make the yield payments without the income. They would lose the yield spread, as it were. This would obviously reduce bank profits. Bank stock prices would be reduced, further reducing values to the stock-holding public.

The result on business and real estate borrowers would be negative; the action would create yet another disincentive for banks to make loans. If the government can require banks to write down loans, this is an added risk to making future loans. In addition to the public's reduced ability to get loans, loan originators (people) in banks will see their income cut and maybe their jobs. This would be a further drag on our economic recovery.

At my superficial level of understanding the banking business, this looks like a lose-lose-lose program: banks-government-people.

Bill Wade

To add a little balance to the post, a July 30 article in Mortgage News Daily, Lt. Gov Tells SIFMA "Back off" Eminent Domain Threats, explains that California Lieutenant Governor Gavin Newsom has called on the Securities Industry and Financial Markets Association ("SIFMA") to "back off" its criticism of the plan: 

This may be an aggressive idea, but communities such as San Bernardino, Chicago and others have no choice in these desperate times. [] We cannot allow Wall Street, who exploited the housing market for financial gain, to kill an idea before it is given a fair hearing.

Finally, despite the increasing number of commentators who have raised serious concerns about the plan's viability, reports are that it continues to gain momentum.  A July 31 article in the San Francisco Chronicle, Eminent domain plan gaining support, points to Berkeley, Oakland, and Chicago as communities now exploring the idea.   

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