New public funding plan: Seize home mortgages

richmond, ca postcardJune 7, 2013

By Wayne Lusvardi

With pension costs sapping budgets, governments at all levels are coming up with novel funding methods. The latest comes from the city of Richmond, which must deal with a looming 50 percent increase in pension costs amounting to $7 million per year over the next five years.

The city’s idea: use eminent domain to seize over-mortgaged home loans from lenders and re-sell them for a $46 million profit. That would help the city of 105,000 plug a $1.75 million decline in sales tax revenues and $7.9 million in additional costs from the negative effects of foreclosed properties in 2012.  About 49 percent of all mortgages in Richmond are classified as “underwater” — meaning the amount of the mortgage on a home greatly exceeds its current market value.

Richmond is another troubled East Bay city, just 12 miles up the 580 freeway from Oakland. Except for a few cities, such as university-town Berkeley, most of these cities have missed the tech prosperity of San Francisco and Silicon Valley to the southwest.

As the San Jose Mercury News reported last month, Richmond has $712 million in negative equity in over-mortgaged homes. That equates to $153,151 on average for each of the 4,649 over-mortgaged homes in the city.

According to Zillow.com, the median home value in Richmond dropped from $311,000 in 2008 to $157,000 after the bursting of the Mortgage Bubble. That’s a $154,000 decline, or 50 percent. Home values have begun rising lately, in just the last by 24 percent to about $200,000. But that’s still way off the peak of 2008, and could be another housing “bubble” about to burst.

Richmond tried to plug its looming budget shortfalls by putting a $6 million local sales tax increase called Measure D on the ballot in 2011. It would have boosted the sales tax rate from 9.75 percent to 10.25 percent. Voters heartily shot it down, 57 percent to 43 percent.

But voters would have no say on the new idea of eminent domain seizures of mortgages. No voters would have to approve mortgage eminent domain.  No municipal bonds would have to be issued or paid back with interest. The city would not have to fight labor unions to unwind pension obligation contracts.  It would be a new way to raise taxes: condemn mortgages from banks and re-sell them back to the same homeowners to reduce their mortgage payments.

How does secondary mortgage market work?

Mortgages are typically not held by the banks that originated the loans, but by what is called a secondary mortgage market. (This is not the same as getting a second mortgage on your home.)

Instead, the investors in the secondary mortgage market are typically pension funds, insurance companies, hedge funds and governments.

The mortgage market buys and sells mortgages based on discounts according to their yield and risk.  The discount is lower for loans where the borrower is making payments and higher for those who have defaulted.  A typical discount for a defaulted loan is 20 percent or higher.

How would mortgage eminent domain work? 

Richmond’s mortgage re-seller, Mortgage Resolution Partners, proposes to “cherry pick” the best performing mortgages out of a secondary mortgage market lender’s portfolio.  But it would buy these high-grade mortgages based on the 20 percent discount for low-grade “bad” mortgages.  It’s sort of like going to an auto dealer and picking only the new cars, but paying for them based on the discounted price as if they were used cars.  This is why the banking and real estate industries are strongly opposed to the use of mortgage eminent domain.

An example provided by Mortgage Resolution Partners: A home with a $300,000 mortgage is now only worth $200,000 in the open real estate market. The mortgage re-seller would buy that $200,000 loan for, say, $160,000, based on a 20 percent discount of the value of the real estate.  A new loan for $190,000 would be offered the homeowner by the mortgage re-seller. The mortgage re-seller would make a $30,000 profit ($190,000 minus $160,000).

The city’s mortgage re-seller would then split the $30,000 in profits: $10,000 for its expenses including a $4,500 fee or profit; $10,000 profit off the top for its investors; and $10,000 to the city.  A detailed breakdown this example is provided below.

In this example, the current owner, the secondary mortgage lender’s investors, would lose $140,000. (The original $300,000 mortgage would be cut down to $160,000; producing a $140,000 loss.)

The investors for Mortgage Resolution Partners would provide $190,000 in new loan money to the homeowner.  However, real estate brokers are afraid lenders would not make any more home loans in Richmond. The only market for homes could thus be “all-cash buyers,” which is what happened in the Great Depression of the 1930s. Thus, homeowners would get a mortgage reduction, but could not be assured of being able to re-sell their homes due to a lack of loan money for new buyers.

Mortgage Resolution Partners’ investors would make $10,000 in pure profit on top of whatever mortgage interest rate they would receive on the new loan.  So this is a scheme whereby Mortgage Resolutions Partners’ investors would reap a windfall at the expense of the secondary mortgage investors (pension funds, insurance companies, etc.).

The Mercury News reported there are 4,649 over-mortgaged properties (also called “underwater mortgages”) in Richmond.  The city would stand to reap about $46 million if the courts approved such a scheme.

You can’t take the well without buying the whole farm

An unaddressed legal obstacle for the city is whether eminent domain probably cannot be used to selectively take the best mortgages out of lender’s pool of loans without valuing the whole mortgage portfolio.  For example, under eminent domain law, government cannot take a farmer’s water well and underground water rights without paying damages to the whole farm.  How the city of Richmond and Mortgage Resolution Partners could expect any court to approve its scheme is a highly dubious assumption.

Richmond understandably is desperate. As with so many California cities, such as bankrupt San Bernadino and Stockton, it spent too much during the good times and now is struggling during the bad times.

However, here is the biggest unmentioned drawback of mortgage eminent domain: If it were enacted and passed the legal hurdles, what could stop a city from just seizing home equity, personal bank accounts or any other assets?

Detailed Breakdown of Eminent Domain Mortgage Example

Amount MortgageRe-Seller/Mortgage Resolution Partners Homeowner Loan Balance Secondary Mortgage Market Lender City of Richmond
Mortgage balance $300,000 $300,000 $300,000
Home value in real estate market $200,000 $200,000
Amount Over-Mortgaged $100,000 $100,000
Amount loan acquired for by eminent domain $160,000 $160,000 $160,000
Mortgage Lender’s Loss $140,000 ($140,000)
Percent Loan Discount (Loss) 47%
Amount New Loan to Homeowner $190,000 $190,000 $190,000
Homeowner Loan Reduction $110,000 $110,000
(37%)
Amount New Loan Markup by Reseller $190,000($160,000)=$30,000 $30,000
Re-Seller’s Expenses $5,500 $5,500
Profit to Re-seller $4,500 $4,500
Profit to Re-seller’s Investor’s $10,000 $10,000
Profit to City $10,000 $10,000

 



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