Reducing the loan principal on devalued real estate is a bitch - just ask officials in San Bernardino County, where more than half of home mortgages are underwater.
Since the housing bubble burst in 2006, the market has been wonderfully efficient at tracking depressed fair market value, but it's completely gridlocked over who books the loss.
Mortgage write-downs present a classic collective action problem - each party's defense of individual rights prevents rational solution for the group. As one result, no federal or state program has brought significant relief to the roughly 11 million borrowers nationwide whose home loans are currently underwater.
San Bernardino County in particular is in a bad way - so bad that in July the City of San Bernardino, the county seat, filed for bankruptcy. Facing a similar outcome, the county board of supervisors began talks earlier this year with Mortgage Resolution Partners (MRP), a San Francisco-based investment firm that offered to help.
Based on those discussions, the county and the cities of Fontana and Ontario formed a joint powers authority that contemplates exercising eminent domain to acquire underwater mortgages in a Homeownership Protection Program. That would permit buying securitized loans that are held in trust agreements, as well as second liens if the holders are unwilling to sell.
News of the program escaped in a trickle, and then produced a flood of reaction from lenders, loan servicers, mortgage securitizers, bondholders, and their assorted lawyers. MRP's proposal to use a public entity's powers of eminent domain to seize and flip home mortgages has been called everything from a "four-bank pool shot" to a "caper" and - in a Wall Street Journal
editorial - "An Eminently Bad Idea
A letter sent to San Bernardino's supervisors signed by 18 national and statewide financial associations warned that the MRP program "raises very serious legal and constitutional issues." Both the American Securitization Forum (ASF) and the Securities Industry and Financial Markets Association (SIFMA) followed up with separate legal memos, the latter one a 16-page broadside submitted by O'Melveny & Myers.
In addition, MRP's bona fides were raked over and examined. Chairman Steven Gluckstern is a wealthy entrepreneur and former fund-raiser for Barack Obama; Phil Angelides, until recently MRP's executive chairman, had chaired the administration's Financial Crisis Inquiry Commission. Very quickly, MRP's big idea took on a political cast.
Opponents of the proposal had a lot of material to choose from: MRP's proposed business model, the shaky legal authority supporting it, and countless practical and procedural issues. The main supporting document for MRP's program was provided by Robert C. Hockett, a professor at Cornell University Law School who has written widely on housing finance issues. Hockett's 55-page memo, however, is long on social policy and short on details. Still, he revealed a few specifics: After a showing of "overriding need," the county would rely on California's "quick take" eminent domain proceedings to seize mortgages before their fair market value could be adjudicated. Only performing loans - those underwater but still current in payments - would qualify for the program. And the mortgages would have to be currently securitized in private-label - rather than government-backed - trusts.
Hockett proposes that the plan's sponsor acquire loans with no more than an 85 percent loan-to-value ratio and refinance them with a government-backed mortgage at a 95 percent loan-to-value ratio based on the properties' "foreclosure-discounted" fair market value. By flipping the loan to a government-secured mortgage, MRP would capture the increment for investors supplying the capital - and earn a fixed fee on each loan.
According to Hockett's memo, "each municipality will have preserved neighborhood integrity, property values, and the revenue base from which it funds services." The losers appear to be holders of the securitized mortgages held in trusts - which prompted a swift reaction from the securitization industry.
Critics of the plan questioned how performing loans, kept current by homeowners despite the property's drop in value, could be sold at foreclosure-discounted prices. "The MRP proposal is predicated [on] not
paying fair market value for performing loans," says Anthony T. Caso, associate professor at Chapman University School of Law in Orange.
O'Melveny's memo, submitted to SIFMA and posted in July, outlined potential legal challenges - among them, impermissible takings under the U.S. and California constitutions; violations of the contracts clause and the commerce clause of the U.S. Constitution; and a direct contravention of a San Bernardino County charter provision prohibiting the use of eminent domain to transfer property from one private party to another. Most telling, it indicted the plan as a risky endeavor that would be subject to countless procedural hurdles and protracted litigation exposing the joint powers authority and the taxpayers to "potentially enormous liability."
"Under present law, the U.S. Supreme Court would probably allow it as a public use," says Gideon Kanner, an eminent domain expert at Manatt, Phelps & Phillips in Los Angeles. But he adds, "the Court was scalded by intense anger over its Kelo
decision," which permitted exercise of eminent domain for comprehensive economic development to benefit a private interest. (Kelo v. City of New London
, 545 U.S. 469 (2005).) "In a challenge to this proposal," Kanner says, "it's possible the Court would pull up its socks and increase its standing with the American people."
Kanner notes that the constitutional issues are nothing compared to "the real problem" with MRP's proposal: loan valuation. "What is the public purpose of taking a performing loan?" he asks. "How does a loan generating present capitalized cash flow qualify for 'foreclosure discount' on fair market value? What happens to the second-lien holders, who are entitled to compensation only to the extent that fair market value is reduced. And what about bondholders in the securitized mortgages, who would be owed severance damages because of a partial taking?"
Tom Deutsch, executive director of the ASF, says, "This is essentially a zero-sum game - money from investors goes into MRP's pockets." Deutsch's ten-page letter to the San Bernardino supervisors ended with a litany of practical problems MRP's proposal should expect to encounter: qualifying for "quick take" proceedings, providing notice to the holders of each note, establishing jurisdiction for notes held outside the county, and the time-consuming process of determining valuations in court.
"What is proposed is an obvious, intentional taking that hurts investors in mortgage-backed securities," says Isaac M. Gradman, principal at the consulting firm I.M.G. Enterprises in Petaluma. "I think they should sue - but will
And in that question lies the beauty of the proposal. Gradman, who writes The Subprime Shakeout
legal blog, contends that investors don't like to litigate, and the trustees holding the securities aren't likely to step forward, either. "The percentage of loans from San Bernardino County in these trusts is very small - probably less than 1 percent," he says. "Where is the incentive for the trustees to litigate?"
Gradman adds, "I read O'Melveny's legal memo as a shot across the bow. It's an attempt to be part of the conversation" should jurisdictions ever use eminent domain to seize mortgage loans and courts attempt to adjudicate who absorbs the lost value.
For its part, San Bernardino County hasn't blinked. "We have been in conversation with the county's chief executive officer," the ASF's Deutsch said last summer. "The joint powers authority intends to go forward with a request for proposals sometime in the fall."
So after six years of stalled federal and state mortgage relief programs, it's left up to a desperate county to finally take collective action.