Let me put it in simple terms. An idea has been floating around for a while now that, in theory, you could use eminent domain to seize not just the houses, but the mortgages on the houses. Let's say that someone had borrowed $200k, but the house was now worth $100k. If you were a local government, you could seize the mortgage from the mortgage holder paying them compensation of, oh, $80k, tear it up, then the home owner gets a new mortgage for $90k, and gives you the proceeds, which would pay you back for the compensation you had to give the mortgage holder, and leave you with $10k to cover your overheads, fees, court costs, and maybe even leave something over for the group of highly altruistic bankers pushing this scheme.
This is normally where I would say "but there's just one problem", but that would be a lie, because there's at least three.
1) The constitution, post Kelo, is pretty lax about needing a good reason to deploy eminent domain, but it's still quite strict about the compensation needing to be fair (ie, the market value). The market value of a $200k mortgage for a $100k house is NOT $80k, or even $100k. Even if the mortgage is currently in default, it still represents ownership of a house worth $100k; by definition that makes it worth $100k, no $80k...and many mortgages won't default at all; even the ones who will eventually will be making payments in the meantime. So right off the bat, legal analysts are confident it's unconstitutional. (But the city can't offer the actual market value of the loan; they're broke.)
2) Banks are going to be very displeased. Except that's a lie; in the US banks don't actually make mortgages. The Federal government does (more than 90%, in point of fact), through the FHA. And they have already stated that they think this is the worst idea since forever, and they will take whatever steps necessary to shut it down, including just not making any more loans for houses in the region. Which in context is basically the nuclear option; the value of a house which can't get a mortgage is pretty much $0. The scheme absolutely relies on being able to get a new mortgage on the houses.
3) Just as if that wasn't enough, the IRS has a lot of very strict rules involving gifts. And buying someone's loan and tearing it up counts as a gift, and you have to pay tax on it. Quite a lot of tax, as it happens. And the homeowners in question don't have the cash, nor would they be thrilled at their massive tax bills even if they did. Which, again, kills the scheme.
4) It's also not entirely clear that this would be good policy even if it worked. This isn't the first attempt at trying to "fix" the problem of underwater mortgages, but results so far have been mixed at best. Then there's the broader policy implications of a bailout. Once you crunch through the likely results of the program, it's not exactly "take from the banks and give to the poor". The banks don't actually own mortgages, and the poor don't actually own houses. It actually ends up being "take from the pension funds and split the results between the middle class and some bankers". Makes for great soundbites, but it's not exactly Robin Hood and Sherwood Forest here. More like the Sheriff of Nottingham.
TL;DR: The plan is illegal, the federal government has already announced that they're putting a stop to it (and they hold all the cards in the mortgage market), it wouldn't work anyhow, and it's probably bad policy even if it did. It's been called a "scam", and frankly, that's pretty accurate.
Edit: From the article: "He's actually the guy responsible for it all: Steven Gluckstern, a former insurance executive who had teamed up with Vlahoplus to co-found Mortgage Resolution Partners, the firm that's lining up the capital -- from hedge funds, for instance -- to buy any mortgages that Richmond might seize. After that happens, Mortgage Resolution Partners would help the homeowner refinance through a Federal Housing Administration loan, and earns a $4,500 fee per successful transaction." Keep in mind that the FHA has said they won't make the loans. The scheme, at its core, is for some bankers to use hedge fund money to grab assets from pension funds, then refinance it using super-cheap loans from the FHA to turn a quick buck. But the FHA has stated it won't make the loans, so the scheme is D-E-A-D dead.
I don't think the plan will work either (for many of the reasons you've given), but I'm not as sure about this one:
The market value of a $200k mortgage for a $100k house is NOT $80k, or even $100k. Even if the mortgage is currently in default, it still represents ownership of a house worth $100k; by definition that makes it worth $100k, no $80k...
The market value of the mortgage is whatever it would actually sell for on the open market. I don't see a strong reason to believe it would always be equal to the price the underlying asset would sell for. Sometimes owning the mortgage is more valuable than the underlying property, because you've locked in a good interest rate and cash stream. Other times it's less valuable, because you have potential hassles over eviction, damage, etc., or because you've locked in a bad interest rate (the latter being the same reason bonds can be worth less than their face value).
In a situation like Richmond's housing market, with high default rates, it wouldn't be too surprising that an unencumbered property could sell for more than a mortgage on the same property would sell for. If I were buying, I would certainly demand a discount on the property to compensate for the risks of taking over the mortgage and a house with a resident in it, versus the situation of buying the property completely free and clear. That's not even specific to mortgages; any asset with a contract attached to it will be valued by taking into account the contract.
> The market value of the mortgage is whatever it would actually sell for on the open market.
Yes. But as a practical matter, the market value of an underwater but performing loan is going to be significantly higher than the underlying asset, and most of the loans in the pool Richmond is looking at are performing.
A defaulted loan might be worth nothing more than the underlying asset less foreclosure costs (which can, as you note, be high); in some cases that might work out to be around 80% of the house value (which is what Richmond plans to offer), so in a small minority of cases Richmond's plan may pass constitutional muster. Unfortunately, their plan then relies on turning around and having the same home buyer get a new mortgage. I'll give you three guesses as to how easily a guy who just defaulted on his last mortgage will get a new one on the same house...
In short, yes, valuing mortgages is complicated. But they are liquid, traded investments, and the market price is simply higher than Richmond is offering on average. And the minority where it isn't won't work on its own.
It's an interesting hypothetical, but presumably there is data about how much mortgages are worth along all these axes, since they are traded fairly heavily. We don't need to guess about it.
The challenge here is that the mortgage has a different valuing scheme than the property. The mortgage is valued against the rate of return and the risk of default. The property is valued against comparable properties.
The whole problem here is that you might have a $200K mortgage which is written to a very credit worthy borrower who is paying on time, against a house with a market value of $100K (probably not in the Bay Area but this is just an example).
So the fair market value of a $200K mortgage, that matures in 2033 might be $100k (this is essentially a zero coupon bond at this point and we're assuming a 3.5% rate of return) could be "destroyed" (which is to say seized by eminent domain) and replaced with a $100K mortgage that matures in 2043 (assuming a 30 yr mortgage). That is worth something like $35,000 (again assuming an annual rate of 3.5%) which quite a bit less than $100K,
So looking at it as an investor you've had $100K worth of "principal" stolen from your retirement account by the City of Richmond, and sold to someone else for basically 1/3 the price, because the underlying basis for this particular investment vehicle was someones home, which is now underwater value wise.
The saddest part of the mortgage mess is that it is so freakishly complicated to figure out what or who owns a mortgage in the world of derivatives. If Richmond is successful (and I hope they are) the next story will be people who have this sudden drop in their 401k investment value with a note "Funds taken by City of Richmond" ) and those folks are going to go "WTF?" and the next round of scare stories will be "Richmond just yanked nearly a billion dollars out of people 401k funds and gave them to a Hedge fund, could you be next?" And nobody will be calling for the real reform which is some level of regulation on what you can and cannot do with a home mortgage security.
The far market value of a house is not the sales price or the appeased value. You need to subtract transaction costs. For your average bank trying to do a quick sale they might get ~80% or less of the appraised value depending on a host of factors which is why 20% down payments are considered so important. As to mortgages if you look at the mortgage resale market you again need to subtract servicing costs which significantly impact actual value.
Worth less than it costs to build is a more appropriate way of phrasing it. Houses in Richmond are substitutable, to some extent, by buying where mortgages are available. So the depth of the house "order book" in Richmond would be very shallow. It wouldn't be $0, but it would be a lot less than in places you can get a mortgage.
Hi, thank you for your insightful comment. Can you provide a source for the sentence "The Federal government does (more than 90%, in point of fact), through the FHA."? I am unable to find any similar statistics. Thanks.
I don't have a link to hard data, but it's a widely reported fact.
> An estimated 90% of all mortgage issuance is government-related (either Fan/Fred or Ginnie). The government now bears 50% of the credit risk of the entire mortgage market. For all intents and purposes, the U.S. mortgage market is more or less nationalized.
> Currently, the government backs about 90 percent of newly issued mortgages, more than ever before. The proportion fell in the years leading up to 2007 as subprime loans proliferated and then soared after that market collapsed. Since then, the Federal Housing Administration has expanded its role in backing home loans on the low end of the scale.
Any way you slice it, the government has a HUGE role in mortgage issuance in the US. And they have said:
> The federal housing agency, which regulates Fannie and Freddie, on Thursday made clear it doesn't intend to let this happen. The agency said it would instruct Fannie and Freddie to 'limit, restrict or cease business activities' in any jurisdiction using eminent domain to seize mortgages.
> buying someone's loan and tearing it up counts as a gift
Through 2013 forgiveness of the mortgage on the debtor's principal residence is not taxable. If the law is not extended, there will spring up an industry to do wash sales of property so that the capital loss can be taken at the same time as the forgiveness.
Let me put it in simple terms. An idea has been floating around for a while now that, in theory, you could use eminent domain to seize not just the houses, but the mortgages on the houses. Let's say that someone had borrowed $200k, but the house was now worth $100k. If you were a local government, you could seize the mortgage from the mortgage holder paying them compensation of, oh, $80k, tear it up, then the home owner gets a new mortgage for $90k, and gives you the proceeds, which would pay you back for the compensation you had to give the mortgage holder, and leave you with $10k to cover your overheads, fees, court costs, and maybe even leave something over for the group of highly altruistic bankers pushing this scheme.
This is normally where I would say "but there's just one problem", but that would be a lie, because there's at least three.
1) The constitution, post Kelo, is pretty lax about needing a good reason to deploy eminent domain, but it's still quite strict about the compensation needing to be fair (ie, the market value). The market value of a $200k mortgage for a $100k house is NOT $80k, or even $100k. Even if the mortgage is currently in default, it still represents ownership of a house worth $100k; by definition that makes it worth $100k, no $80k...and many mortgages won't default at all; even the ones who will eventually will be making payments in the meantime. So right off the bat, legal analysts are confident it's unconstitutional. (But the city can't offer the actual market value of the loan; they're broke.)
2) Banks are going to be very displeased. Except that's a lie; in the US banks don't actually make mortgages. The Federal government does (more than 90%, in point of fact), through the FHA. And they have already stated that they think this is the worst idea since forever, and they will take whatever steps necessary to shut it down, including just not making any more loans for houses in the region. Which in context is basically the nuclear option; the value of a house which can't get a mortgage is pretty much $0. The scheme absolutely relies on being able to get a new mortgage on the houses.
3) Just as if that wasn't enough, the IRS has a lot of very strict rules involving gifts. And buying someone's loan and tearing it up counts as a gift, and you have to pay tax on it. Quite a lot of tax, as it happens. And the homeowners in question don't have the cash, nor would they be thrilled at their massive tax bills even if they did. Which, again, kills the scheme.
4) It's also not entirely clear that this would be good policy even if it worked. This isn't the first attempt at trying to "fix" the problem of underwater mortgages, but results so far have been mixed at best. Then there's the broader policy implications of a bailout. Once you crunch through the likely results of the program, it's not exactly "take from the banks and give to the poor". The banks don't actually own mortgages, and the poor don't actually own houses. It actually ends up being "take from the pension funds and split the results between the middle class and some bankers". Makes for great soundbites, but it's not exactly Robin Hood and Sherwood Forest here. More like the Sheriff of Nottingham.
TL;DR: The plan is illegal, the federal government has already announced that they're putting a stop to it (and they hold all the cards in the mortgage market), it wouldn't work anyhow, and it's probably bad policy even if it did. It's been called a "scam", and frankly, that's pretty accurate.
Edit: From the article: "He's actually the guy responsible for it all: Steven Gluckstern, a former insurance executive who had teamed up with Vlahoplus to co-found Mortgage Resolution Partners, the firm that's lining up the capital -- from hedge funds, for instance -- to buy any mortgages that Richmond might seize. After that happens, Mortgage Resolution Partners would help the homeowner refinance through a Federal Housing Administration loan, and earns a $4,500 fee per successful transaction." Keep in mind that the FHA has said they won't make the loans. The scheme, at its core, is for some bankers to use hedge fund money to grab assets from pension funds, then refinance it using super-cheap loans from the FHA to turn a quick buck. But the FHA has stated it won't make the loans, so the scheme is D-E-A-D dead.