Will 'trapped loans' snag Richmond's home scheme?

 
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The City of Richmond's move to seize the loans of over-mortgaged homes can continue, U.S. District Court Judge Charles Breyer ruled this week. According to the San Francisco Chronicle, the reason was because “he felt the case, brought by Wells Fargo and Deutsche Bank on behalf of holders of loans on over-mortgaged homes, was not 'ripe for determination' since Richmond had not exercised eminent domain and might never do so.”

Despite an initial win in federal court, will Richmond first have to prove that loans on over-mortgaged homes in its city are “trapped” to meet the “blight” criteria of California redevelopment law? A recent study by the Wall Street Journal indicates that Richmond would have to prove loans on over-mortgaged properties are “trapped” before they can justify there is public necessity to take the loans.

A “trapped” loan is where a government secondary mortgage market lender such as Fannie Mae or Freddie Mac won’t buy up sub-prime mortgages from primary lenders or other secondary lenders.  Therefore, homeowners with over-mortgaged homes cannot refinance by taking advantage of HARP or other mortgage payment programs. Their high-interest rate loans are “trapped” without any ability to refinance.

Richmond would have to prove “blight”

Wall Street Journal reporters Michael Corkey and Al Yoon sampled 36 out of 1,726 loans left in mortgage loan pool called CWABS Asset-Backed Certificates Trust 2006-7.  CWABS is an abbreviation for Country Wide Asset-Backed Securities; 836, or 48 percent, of homeowners in CWABS 2006-7 are current in their payments.  About half of the mortgages in CWABS 2006-7 are from California and Florida.

The U.S. Securities and Exchange Commission presently manages this loan pool.  Originally, the loan pool consisted of 5,954 mortgages.  The Journal did not report if the 4,228 loans no longer part of the pool were foreclosed, paid off, or refinanced by other lenders.

To undertake its eminent domain loan payment reduction program, Richmond must file a Resolution of Necessity in Contra Costa County Superior Court justifying the reason why taking mortgages out of a lender’s loan portfolio serves a public purpose.  Eminent domain law gives wide discretion to governments as to what qualifies as public purpose.  However, cities must typically prove “blight” to justify the use of eminent domain for economic purposes. Under California law blight is defined as:

“An area that is predominantly urbanized…and…it constitutes a serious physical and economic burden on the community which cannot reasonably be expected to be reversed or alleviated by private enterprise or governmental action, or both, without redevelopment.”

However, there is no public necessity to take loans on over-mortgaged homes where the homeowners can avail themselves of loan reduction programs, can short sale their homes for less than the loan balance, or are in default and can be foreclosed. Conceivably, all those actions would prevent or alleviate neighborhood blight in the long run.

There may be a private necessity to renegotiate an over-mortgaged home loan.  But aggregating the private necessity of all the over-mortgaged home loans in Richmond does not necessarily make a public necessity.

The City of Richmond incurred $7.9 million in 2012 in extra costs to prevent foreclosed homes from “blighting” neighborhood home values.  Therefore, it would only be those homes where there would be a public necessity to prevent blight. But those homes are no longer over-mortgaged.

Loans on over-mortgaged homes where homeowners are making payments are not causing “blight.”

To further learn how mortgages become “trapped” one has to understand how the primary and secondary mortgage markets work.

The secondary mortgage market

The secondary mortgage market is for the sale of securities or bonds in which the collateral is a pool of mortgage loans.  There are five layers of participants in the government-regulated mortgage market:

1) Borrowers.  These are homeowners whose loans have been re-sold by their bank to secondary banks;

2) Primary lenders or loan originators consisting of banks and mortgage banks;

3) Aggregators or secondary mortgage market banks like the federal government’s Fannie Mae  and Freddie Mac. Because of the risk of holding loans that might default, government-sponsored aggregators hedge their risk by “securitizing” them into bonds and other debt instruments.

4) Securities Dealers who sell the re-packaged loans to investors; and

5) Investors, which could be pension funds, insurance companies, and foreign governments.

One of the objectives of this many-layered loan system is to buy the loans off of the primary banks so they can make more loans to homeowners.  Each layer of the secondary mortgage market buys pools of loans based on risk-based discounts.

In the case of the City of Richmond’s mortgage consultant, Mortgage Resolution Partners is a mortgage securities dealer that buys loans on discounts.  It believes that if Richmond can take the loans on over-mortgaged homes away from primary lenders by eminent domain, it can re-sell the loans to investors at a discount and pass that discount back to the homeowners.  Mortgage Resolution Partners would also provide a $46 million windfall to the City of Richmond.

But an unresolved question is: who pays the investors of the primary and secondary mortgage lenders for the difference in the balance due on the loan and the discount price in the securities market?  The position of the City of Richmond and its mortgage securities consultant is: It's not their problem.  They believe they can stick the investors of primary banks with losses because the market value of the loan is worth less in the securities market.

However, an unresolved issue is: Would over-mortgaged homeowners eventually be stuck with paying off the investors of primary lenders when the homes are sold at a windfall profit?

Eminent domain law explicitly requires that the property owners be made whole for any losses. But what happens to the investors of the banks that are holding the loans?  So the whole scheme by the City of Richmond may backfire.  Here is where “trapped loans” come into the picture.

“Trapped Loans”

The City of Richmond’s scheme is to offer loan reductions to homeowners who are current on their loans payments.  Richmond would even go so far as to reduce the loan balances on million-dollar homes, which obviously are not blighted.

Richmond has a point that the loans contained in CWABS 2006-7 are high-interest sub-prime loans. CWABS 2006-7 is a high-interest rate loan pool averaging 8.5 percent, but ranging as high as 15 percent.

However, for homeowners to avail themselves of government loan payment reduction programs such as HARP (Home Affordable Refinance Program), their loan must be guaranteed by Fannie Mae or Freddie Mac.  Fannie and Freddie refused to invest in bonds loaded with so-called subprime loans.  The buzzword in the mortgage industry for high-rate loans that can’t be refinanced due to government rigamarole is “trapped.”

Because lenders have limited offering HARP 2.0 loans to only their own customers, they can raise rates on other homeowners with trapped mortgages and earn more than the market interest rate.

This raises the question, however, whether an eminent domain action is the appropriate legal action to correct this situation?  The definition of economic “blight” cited above specifies that it is where an economic burden is inflicted on a community that can’t be reversed or lessened by the private or government sectors or both.  The only types of properties that would meet this definition would be those with “trapped” mortgages.  All other types of homeowners with over-mortgaged homes have either private or public options available that would reverse or alleviate community blight.

Legally complex eminent domain actions in California are usually handled by bifurcating the trial into a “legal issues phase” and a “valuation issues phase.”

Such a pathbreaking use of eminent domain by the City of Richmond could take as much as a year just to decide the legal aspects.  Because Richmond may not be able to easily establish “public necessity,” it is unlikely that a court would authorize the automatic taking of mortgages with the value issue to be handled later.

But whatever happens in California’s court system, the matter of “trapped mortgages” is going to have to be raised.