The latest false-hope-for-loanowners news story is San Bernardino County’s idea of using eminent domain to foreclose on mortgages. The idea is completely untenable, and it will not come to pass, but many loanowners hoping for principal reduction are latching on to this “hail Mary.” With as awful as this idea is, there is one bright spot I can embrace. If lenders really thought a local government body could force them to write down underwater mortgages through eminent domain, they would be much more concerned with the prospect of inflating another housing bubble. In the post Strategic default is moral imperative to prevent future housing bubbles, I argued strategic default was necessary to force lenders to recognize their losses and deter them from inflating future bubbles. If eminent domain were exercised by cities, it would have the same chilling effect.
Problems with the eminent domain strategy
First, it must be determined that eminent domain of mortgages is in the public’s best interest. In a recent dipshit editorial in the New York Times, the author asked, “Can there be any doubt that keeping people in their homes constitutes a legitimate public purpose?” Well, actually there is some doubt on this point. First, this is interference in a private contract between two parties that has no bearing on the broader general public. Condemning these mortgages benefits the individuals who receive mortgage write downs at the expense of those who are due payments on these loans. There is no public good in that. Plus, any principal reduction is laden with moral hazard which is a detriment to the public good.
Second, the value of these mortgages is not the value of the underlying collateral. In an eminent domain process, the parties must agree on the value of the asset being acquired. If they don’t it goes to court, which most of these cases undoubtedly will. The banks hold these notes, both performing and non-performing, on their books at original book value minus any amortization. In an eminent domain proceeding, the lender will argue that is the value of the mortgage. If banks must abandon mark-to-fantasy accounting on their non-performing loans and must mark these loans to market — something a successful eminent domain proceeding would force to happen — then the losses to banks and investors will be staggering. Most of the banks will be proven insolvent.
In the case of performing loans, the situation is much more difficult because the banks can rightfully argue the loan is still worth its full face value. After all, the borrower is still paying as agreed. The value of that note is face value if the borrower continues to pay until prices recover. If the city starts an eminent domain proceeding on a performing loan, they will be forced to pay full face value for the loan, then they will be the bagholder if the borrower defaults.
Think what happens then if the city uses eminent domain on non-performing loans and gives those borrowers principal reduction and fails to acquire any performing loans. This would create a huge incentive to strategically default. Basically, any loanowner who quit paying the mortgage would get principal reduction and any loanowner who kept paying would get nothing. Does the city want to buy every mortgage in town? Once this got rolling, they would have to because everyone would quit paying to get the debt relief.
What happens to the property if the delinquent borrower whose mortgage the city just bought does not want to make a deal? The false assumption behind this plan is that every underwater loanowner wants to stay in the property and pay a mortgage. What if the former loan owner doesn’t want to accept the city’s new terms for the loan? Will the city then foreclose and boot them out like the banker would have? What will the cities do with the homes they acquire this way?
Third, the ability to use eminent domain gives the city the opportunity to play the real estate cycle for its own benefit. What if cities start using this to acquire vacant houses or offices? The city could buy up the distressed properties to profit from the rebound. Is this something we want cities doing?
Eminent domain as bubble deterrent
If lenders faced the risk that they may be forced to write down principal balances in the event of a price drop — something the precedent of using eminent domain to acquire underwater mortgages makes real — then lenders would adjust their lending practices going forward. The first thing they would all do is raise their down payment requirements. Since lenders all know 30% to 50% declines in price are possible, then they will start demanding 30% to 50% down payment cushions to protect themselves from potential losses. The only loans with smaller down payments would be government guaranteed loans where the taxpayer makes up the difference for a loss caused by an eminent domain action. The jumbo market would be dead, permanently.
The positive thing lenders would do is to carefully research what causes housing bubbles and enact real changes to prevent them. The bottom line is that prices don’t decline 30% to 50% if prices don’t become grossly inflated. The best thing lenders could do to protect themselves is to determine the cashflow value of the property. If lenders knew they could take the property back and rent it for enough to service the payment, they would have some assurance the property was not overvalued. Of course, this would greatly curtail lending, which isn’t what lenders want, but it’s lender air that inflates bubbles. The fear of eminent domain would go a low way toward preventing the next housing bubble.
San Bernardino County’s plan to help the hard-hit housing sector should prod lenders to do more.
Property values have fallen so sharply in San Bernardino County that nearly half of the homeowners with mortgages owe more than their houses are worth. Hoping to aid at least some of those “underwater” borrowers, the county is considering a novel plan to use venture-capital dollars to buy and refinance their mortgages. The plan’s authors say that homeowners would end up with less debt and the county and its financial backers would make a profit — all without the taxpayers spending a penny. The losers? Supporters say there would be none. We’re not so sure. …
A free lunch, right? Anyone who says nobody losses is a disingenuous liar. Someone has to lose. In this instance, it’s the holders of mortgage notes who are forced to take massive write downs.
To avoid encouraging people to default, the relief would be available only to borrowers who’d remained current on their payments.
This strategy does deal with the strategic default problem, but it runs squarely into the valuation problem. The performing notes are worth considerably more than the underlying collateral, and any judge is going to agree with the banks on this point. The city is not going to acquire performing notes at bargain prices using eminent domain.
It also would be offered only for homes worth at least 15% less than the amount owed, which are the ones most likely to go into foreclosure in the future.
The people who recklessly HELOCed themselves to max get a break, but the more prudent borrowers get nothing. That makes sense, not.
Notably, the new loans would be larger than the “fair market value” paid for the old ones, enabling Mortgage Resolution Partners and governments to profit from each seizure.
So the cities are going to make a profit by stealing from the banks? Only if they acquire the notes at a very low value, and that isn’t going to happen. If San Bernardino or any other city tries this, the first court cases to establish market value of these performing notes is going to blow these cities out of the water.
Although governments have used it in the past to seize all kinds of property in the name of the public good, eminent domain remains a drastic step that, when asserted in a novel way, can send shock waves through a market.
That’s one reason the local officials who’ve talked to Mortgage Resolution Partners haven’t yet signed onto its plan. On the other hand, they have been waiting years for the banking industry and Wall Street to respond more effectively to the foreclosure crisis, and their patience is understandably wearing thin.
Lenders who still own the mortgages they issued are starting to offer meaningful help to troubled and underwater borrowers, but investors who purchased packages of loans on Wall Street are hindered by securities contracts that make it extremely difficult for them to write down individual loans, according to Cornell University law professor Robert C. Hockett, a supporter of the eminent-domain plan. Seizing underwater loans from those complex securities would let local governments do what investors haven’t been able to do for themselves, which is minimize the foreclosures that are reducing the value of their securities.
The foreclosures would not reduce the value of these investors securities near as much as being forced to take a hefty write-down will. What professor Hockett fails to recognize is that these lenders and investors don’t want to write down these individual loans. They don’t perceive giving away money as helping their cause. It doesn’t. It benefits loanowners at the expense of these investors.
The trade groups that represent investors and lenders aren’t buying that argument. They contend that seizing securitized mortgages would spook investors, drying up the supply of money for new mortgages.
These trade groups are right. The eminent domain plan adds a new layer of risk with the potential for huge losses.
Their warnings may very well be exaggerated, but it would be pointless to implement the Mortgage Resolution Partners plan if every use of eminent domain drew a lawsuit.
That means county officials will have to mollify the objectors before moving forward. They also have to make the case that reducing the risk of foreclosures justifies seizing loans regardless of whether the borrowers are capable of paying them off — an approach that raises tough questions about fairness.
Moral hazard is more than a “tough question.” Moral hazard is the central issue in housing bust.
Finally, they need to show that it’s appropriate to use eminent domain to generate profits for one group of investors (and local governments) at the apparent expense of another group of investors.
And how will they prove that one?
Ideally, the county’s deliberations will prod investors to do much, much more than they’ve been doing to avert costly, needless foreclosures and eliminate the overhang of uncollectable debt that’s holding back the economy. If they don’t, however, they shouldn’t be surprised if hard-hit counties such as San Bernardino take the matter out of their hands.
The author of this LA Times editorial has postulated two contradictory solutions. Eliminating the uncollectable debt overhang is certainly necessary to fix the economy; however, foreclosure is the means of accomplishing this task. There are no “costly, needless foreclosures.” There are necessary foreclosures, and the longer we delay them, the longer our economic malaise will continue.
Should Ponzis be eligible for the principal forgiveness program?
Another hidden false assumption of the various principal reduction bailout programs is that all the borrowers who need this help were first-time homebuyers who bought at the peak. This is demonstrably not true. Many, if not most, of these peak borrowers were Ponzis who started with a small mortgage and withdrew hundreds of thousands of dollars in free spending money. If we reset their mortgages, what have they learned? What have we all learned? Who will borrow responsibly in the future? Anybody?
- The former owner of today’s featured property paid $392,000 on 6/1/2001. He used a $350,000 first mortgage and a $42,000 down payment.
- On 2/21/2003 he refinanced with a $452,000 first mortgage.
- On 3/11/2004 he refinanced with a $575,000 first mortgage and obtained a $25,000 stand-alone second.
- On 2/21/2006 he obtained a new $185,000 stand-alone second.
- On 3/7/2011 he got a private loan for $53,875 from a someone who probably lost all his money because he was served with a NOD on 7/8/2011.
This guy extracted $410,000 from his house. How would you feel about the city of Huntington Beach taking the first mortgage on this property in eminent domain and giving him the chance to Ponzi borrow another $400,000? I don’t think that serves the public good. Do you?
Huntington Beach Overview
Median home price is $503,000. Based on a rental parity value of $606,000, this market is fairly valued.
Monthly payment affordability has been improving over the last 12 month(s). Momentum suggests improving affordability.
Resale prices on a $/SF basis increased to $316/SF to $319/SF.
Resale prices have been weak for 12 month(s). Price momentum suggests weak prices over the next three months.
Median rental rates increased $45 last month from $$2,429 to $$2,475.
Rents have been slowly rising for 12 month(s). Price momentum suggests slowly rising rents over the next three months.
Market rating = 4
$649,900 …….. Asking Price
$392,000 ………. Purchase Price
6/14/2001 ………. Purchase Date
$257,900 ………. Gross Gain (Loss)
($31,360) ………… Commissions and Costs at 8%
$226,540 ………. Net Gain (Loss)
65.8% ………. Gross Percent Change
57.8% ………. Net Percent Change
4.5% ………… Annual Appreciation
Cost of Home Ownership
$649,900 …….. Asking Price
$129,980 ………… 20% Down Conventional
3.67% …………. Mortgage Interest Rate
30 ……………… Number of Years
$519,920 …….. Mortgage
$120,388 ………. Income Requirement
$2,384 ………… Monthly Mortgage Payment
$563 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$162 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,110 ………. Monthly Cash Outlays
($377) ………. Tax Savings
($794) ………. Equity Hidden in Payment
$157 ………….. Lost Income to Down Payment
$182 ………….. Maintenance and Replacement Reserves
$2,278 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$7,999 ………… Furnishing and Move In at 1% + $1,500
$7,999 ………… Closing Costs at 1% + $1,500
$5,199 ………… Interest Points
$129,980 ………… Down Payment
$151,177 ………. Total Cash Costs
$34,900 ………. Emergency Cash Reserves
$186,077 ………. Total Savings Needed
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