Rich­mond (CA) once was ranked among the nation’s most dan­ger­ous cities.  If city fathers have their way, it will become the most dan­ger­ous city for res­i­den­tial mort­gage investors.

The city gov­ern­ment in recent weeks offered to buy 624 mort­gages from investors at dis­count­ed prices.  Mort­gage bond trustees act­ed quick­ly to try to stop the city from tak­ing the next step, using its pow­er of emi­nent domain to take the mort­gages away from the investors that own them.  They have asked a fed­er­al judge to block the seizure.

The Rich­mond Seizure Pro­gram rep­re­sents the government’s lat­est incur­sion into a hous­ing mar­ket that remains trou­bled years after the real estate bub­ble burst.  While the mar­ket has shown ample signs of recov­ery over the last year, fore­clo­sures remain at high lev­els and mil­lions owe more on their hous­es than they are worth.  The banks that orig­i­nat­ed these under­wa­ter mort­gages usu­al­ly no longer own them, hav­ing sold them to gov­ern­ment-spon­sored enti­ties or oth­er banks, who bun­dled them into secu­ri­ties and sold them to investors.

Richmond’s pro­gram would work some­thing like this.  Say a home­own­er owes $400,000 on a home that is cur­rent­ly worth only $300,000.  The gov­ern­ment of Rich­mond would use its emi­nent domain pow­er to seize the mort­gage from the own­ers of the secu­ri­ty, pay­ing a price that it deems fair.  The city will rely on its bank­ing part­ner, Mort­gage Res­o­lu­tion Part­ners (MRP), a pri­vate invest­ment fund, to raise mon­ey to buy the loans from bond trusts at the price estab­lished by the city.  MRP would then orig­i­nate a new FHA-insured loan with a prin­ci­pal bal­ance more con­sis­tent with the home’s cur­rent mar­ket value.

Richmond’s action is the brain­child of Cor­nell Uni­ver­si­ty Pro­fes­sor Robert Hock­ett, who has long advo­cat­ed gov­ern­ment seizure of under­wa­ter mort­gages.  I crit­i­cized his pro­pos­al in a pre­vi­ous post and he was very gen­er­ous in engag­ing me in a back-and-forth.

Hock­ett argues that if the gov­ern­ment seized under­wa­ter mort­gages and wrote down the prin­ci­pal, every­one would win: home­own­ers would get more afford­able month­ly pay­ments, com­mu­ni­ties would have few­er fore­clo­sures and less blight, and investors would get bet­ter-per­form­ing mort­gages.  But if writ­ing down the prin­ci­pal ben­e­fits both bor­row­er and lender, why don’t lenders do it?  Because mort­gages that have been bun­dled into secu­ri­ties and sold in the mar­ket­place are owned by such a broad swath of indi­vid­u­als and insti­tu­tions – pen­sion funds, uni­ver­si­ties, foun­da­tions, for­eign gov­ern­ments – that it is impos­si­ble for them to act col­lec­tive­ly.  The gov­ern­ment should address this “mar­ket fail­ure” by act­ing as a col­lec­tive agent, seiz­ing the mort­gages, pay­ing investors a fair price, issu­ing new loans on more favor­able terms to home­own­ers, and sell­ing these loans on the open market.

I argued that there is no “mar­ket fail­ure.”  Gov­ern­ment should not involve itself in help­ing (if it is indeed help­ing) investors who have lost mon­ey on mort­gage-backed secu­ri­ties or in get­ting bor­row­ers out from under their mort­gages. Investors who bought secu­ri­ties backed by sour­ing loans are free to hold them or sell them at a loss; home­own­ers who bor­rowed more than their home is now worth should either con­tin­ue mak­ing pay­ments or default.  I also object­ed to gov­ern­ment using the “tak­ings clause” of the Fifth Amend­ment to seize pri­vate prop­er­ty.  That clause restricts the pow­er to seize prop­er­ty for “just com­pen­sa­tion” to instances where the prop­er­ty is required for “pub­lic use” (e.g., a new road, a mil­i­tary base, a school, or the like).  Pro­fes­sor Hock­ett wants gov­ern­ment to use this pow­er pri­mar­i­ly to ben­e­fit pri­vate actors (investors and under­wa­ter home­own­ers), as well as the local gov­ern­ment, an uncon­sti­tu­tion­al use of gov­ern­ment pow­er, in my judgment.

I also ques­tioned whether pri­vate investors would actu­al­ly ben­e­fit from gov­ern­ment seizure.  That ques­tion has now been answered, at least with respect to the Rich­mond Seizure Pro­gram.  Two banks that issued the secu­ri­ties that include mort­gages that the gov­ern­ment intends to seize – Wells Far­go and Deutsche Bank – have asked a fed­er­al judge to nix the project.  Their com­plaint states:

Defen­dants Rich­mond and MRP seek to enrich them­selves through a prof­it-dri­ven scheme under which Rich­mond would use its emi­nent domain pow­ers, and the threat of emi­nent domain lit­i­ga­tion, pri­mar­i­ly to seize per­form­ing res­i­den­tial mort­gage loans … at steeply and unjus­ti­fi­ably dis­count­ed prices that do not reflect the cur­rent val­ue of the loans, and then refi­nance those loans with new fed­er­al­ly insured loans for amounts sub­stan­tial­ly above the amounts paid by Rich­mond to seize the home­own­ers’ exist­ing loans (pp. 18–19).

The suit alleges that the Rich­mond Seizure Pro­gram, far from being a win-win-win, is a zero-sum – home­own­ers and the city gov­ern­ment ben­e­fit at the expense of investors.  Here it is impor­tant to dis­tin­guish what Rich­mond is try­ing to do from what Pro­fes­sor Hock­ett advo­cat­ed.  Accord­ing to the fil­ing, investors would be paid 80 per­cent of the home’s mar­ket val­ue, not 80 per­cent of the loan prin­ci­pal.  That is an impor­tant dis­tinc­tion. For exam­ple, investors who own a $400,000 mort­gage on a house worth $300,000 would be paid $240,000 by the gov­ern­ment (80 per­cent of the home’s val­ue).  That rep­re­sents a $160,000 loss on the $400,000 mort­gage, a 40 per­cent hit.  I’m not sure that Hock­ett had loss­es of that mag­ni­tude in mind when he devised his proposal.

But if investors lose, the City of Rich­mond and its part­ner MRP win.  Although they would pay just $240,000 (80 per­cent of the home’s mar­ket val­ue) to investors, they would issue a new mort­gage of $285,000 (95 per­cent of the home’s mar­ket val­ue). MRP and the city would then sell the new mort­gage to the Fed­er­al Hous­ing Admin­is­tra­tion (FHA) and divide the $45,000 prof­it, accord­ing to the filings.

In addi­tion to com­plain­ing about gov­ern­ment and MRP prof­it­ing from the seizure, the banks object to the city’s selec­tion of which mort­gages to seize.  Pro­fes­sor Hockett’s writ­ings sug­gest that gov­ern­ment would seize the mort­gages of bor­row­ers who are like­ly to default.  Accord­ing to the fil­ing, Rich­mond is doing the oppo­site: seiz­ing under­wa­ter loans that are not like­ly to go bad.

“The Pro­gram prin­ci­pal­ly tar­gets per­form­ing loans – i.e., the loans of home­own­ers who have been mak­ing their month­ly pay­ments for years despite being ‘under­wa­ter,’ and who have good cred­it rat­ings, as opposed to those loans that are in default or at seri­ous risk of default.  The Pro­gram tar­gets per­form­ing loans because they are not at seri­ous risk of default and there­fore can be eas­i­ly re-financed with a new Fed­er­al Hous­ing Admin­is­tra­tion (“FHA”) insured loan” (pp. 10–11, empha­sis in original).

The com­plaint alleges that the city gov­ern­ment and its bank­ing part­ner are seiz­ing mort­gages that are unlike­ly to default because such loans are the eas­i­est to sell to the fed­er­al government’s own mort­gage insur­ance enti­ty, assur­ing a quick prof­it.  If true, that would seem to under­mine the program’s express pur­pose, which is to pre­vent home­own­ers who have fall­en behind on their pay­ments from being forced into foreclosure.

The Rich­mond Seizure Pro­gram, the banks argue, is an uncon­sti­tu­tion­al exer­cise of gov­ern­ment pow­er by the city of Rich­mond.  It does not meet the Fifth Amendment’s require­ment that gov­ern­ment tak­ings be for “pub­lic use”; nor do the city’s dis­count­ed pay­ments for the mort­gage meet the “just com­pen­sa­tion” requirement.

The mat­ter is now in the courts.  What will hap­pen if the judges rule in favor of Rich­mond?  Expect gov­ern­ment seizure of pri­vate mort­gages to go viral.  MRP already has made pitch­es to oth­er Cal­i­for­nia cities, as well as to Newark (NJ) and Seat­tle (WA) (p. 13).  If Rich­mond wins its case, oth­er cities will sure­ly launch their own pro­grams.  Gov­ern­ments at all lev­els are peren­ni­al­ly starved for cash, and seiz­ing mort­gages promis­es instant prof­it.  Far from antag­o­niz­ing vot­ers by rais­ing their tax­es, this new source of rev­enues could actu­al­ly win the votes of those who ben­e­fit from low­er month­ly payments.

In addi­tion to the law­suit, the pro­gram faces oth­er head­winds.  The Fed­er­al Hous­ing Financ­ing Agency may direct Fan­nie Mae and Fred­die Mac, which it over­sees, not to do busi­ness in any com­mu­ni­ty whose gov­ern­ment seizes pri­vate mort­gages.  The reg­u­la­tor also has ques­tioned whether the FHA would insure mort­gages that cities take from pri­vate investors.  With­out the FHA’s par­tic­i­pa­tion, the pro­gram most like­ly would become unworkable.

The resis­tance of gov­ern­ment reg­u­la­tors to this par­tic­u­lar inter­ven­tion in the hous­ing mar­ket is unusu­al.  Gov­ern­ment intru­sion into that mar­ket has been mas­sive, with the Fed sup­press­ing inter­est rates and buy­ing up $1.3 tril­lion in mort­gage-backed secu­ri­ties, Trea­sury tak­ing over Fan­nie and Fred­die and ply­ing them with $187 bil­lion in tax­pay­er mon­ey to keep them afloat, and var­i­ous fed­er­al enti­ties launch­ing mul­ti­ple pro­grams to write down mort­gage bal­ances for dis­tressed homeowners.

These var­i­ous inter­ven­tions have fall­en short of expec­ta­tions.  Aver­age hous­ing prices, accord­ing to the Case-Shiller 20-city index, are still 28% below where they stood sev­en years ago at their July 2006 peak.  Sales of new and exist­ing homes con­tin­ue to lag lev­els reached before the hous­ing crash.  Mort­gage write-down pro­grams have proven a dis­ap­point­ment.  Last month, the gov­ern­ment report­ed that near­ly half the home­own­ers who in 2009 had their mort­gages reduced under one of these pro­grams — Home Afford­able Mod­i­fi­ca­tion Pro­gram (HAMP) — had default­ed on their new loans.  And the Trea­sury Depart­ment has now giv­en two states  per­mis­sion to use mon­ey from anoth­er pro­gram that was designed to help peo­ple stay in their homes (the “Hard­est Hit Fund”) to tear the homes down instead.

Nev­er­the­less, gov­ern­ment con­tin­ues to inter­vene.  And while banks are hard­ly in a posi­tion to com­plain about gov­ern­ment doing favors for pri­vate actors – the Fed gave Deutsche Bank $2.6 bil­lion as part of the AIG bailout, to cite but one exam­ple — they have it right in this case.

The Rich­mond Seizure Pro­gram is a dan­ger­ous­ly uncon­sti­tu­tion­al idea.  The courts should strike it down.