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The New York Times today reports on the city of Richmond, California and what can perhaps best be described as a hare-brained scheme to ‘fix’ the problem of underwater mortgages by using eminent domain to seize mortgages from the lenders and refinance the homeowners based on the current market value of the home. Here’s how the Times explains the scheme:
The city is offering to buy the loans at what it considers the fair market value. In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default.
Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program. The $30,000 difference goes to the city, the investors who put up the money to buy the loan, closing costs and M.R.P. The homeowner would go from owing twice what the home is worth to having $10,000 in equity.
It’s possible that the writer misunderstood the scheme as it was explained, but assuming this is an accurate description, there’s one pretty obvious flaw in this plan.
The discount that is used to reflect the risk of default looks to be 20%. Reasonable enough – according to this paper on underwater mortgage defaults by the Federal Reserve Bank of San Francisco, default rates peak at around 20% when the loan-to-value gets above 100% (i.e., the mortgage is underwater). There’s a lot more than this that goes into determining the appropriate discount rate, but this is where it starts and it comprises a large part of that rate.
But while the discount rate seems reasonable, it’s being applied to the wrong number.
The value of the mortgage, even discounted for additional risk, is the present value of future cash flows based on the original mortgage, not the lower current value of the underlying asset, in this case the house. So in the extremely simplistic example above, the 20% discount for additional risk would be applied to the cash flows based on the $400,000 loan value, not the $200,000 current value of the house.
This means the city wouldn’t be buying the mortgage for $160,000 in the scenario above (80% of the $200,000 current value of the home), they’d have to pay closer to $320,000 (80% of the value of the outstanding principal, ignoring for simplicity’s sake interest and inflation).
The reason the city would have to pay market value of the mortgage is the Fifth Amendment which states “…nor shall private property be taken for public use without just compensation.” This vital protection is what prevents the government from simply seizing property based on a whim and offering the owners little more than a few pennies on the dollar of its real worth (at least in theory, in practice this isn’t quite how it always works out).
Once you start to run the numbers based on this, it doesn’t look nearly as attractive an option unless the government plans to take a massive loss on each and every mortgage seized. The city would have to pay $320,000 for the mortgage, then either persuade the homeowner to refinance into a mortgage in which they are $120,000 underwater (unlikely), or accept a loss of $120,000 plus whatever it costs them to refinance and administer the process.
The last time I checked, not a lot of cities had the funds to be eating millions or tens of millions of dollars to refinance homes, but maybe Richmond, California is different?
Oh, it should also be noted that a key element in this ill-conceived scheme to seize private property is a private company looking to make a bundle by financing the purchase of old mortgages and writing of new mortgages. The company is called Mortgage Resolution Partners, apparently an affiliate of an investment banking firm called Evercore Partners. I guess this is what people mean when they talk about ‘public-private partnerships.’