There has been a great deal of discussion surrounding the proposal to use eminent domain as a way of evading proscriptions against principal "cram-downs" (i.e., forced reductions in loans' principal balances). As a non-attorney, I'm not going to venture an opinion on the legality or propriety of the proposed seizure of investors' assets. I do, however, believe that the proposed actions would have a damaging effect on the MBS and mortgage markets, and risks injuring the people who are supposed to be aided.
To summarize, a San Francisco-based firm has proposed to finance the acquisition of underwater loans held in private-label MBS trusts by municipalities using their powers of eminent domain. The loans' current holders would be compensated based on a reduced face value, reflecting current home prices. Homeowners would receive new FHA loans reflecting their homes' current values.
The proposed program is designed to seize only loans held in non-agency MBS, presumably to avoid the implications of burdening the GSEs (and, ultimately, taxpayers) with losses resulting from principal write-downs. The broad impact of eminent domain seizures on the private-label MBS market is far from clear. However, the proposal would surely create a new source of exogenous risks for investors in both new and legacy bonds. (While targeted toward older loans, there are no safeguards against future loan seizures if home values decline in the future.) This new form of risk will continue to delay the recovery of the non-agency MBS market, which remains hampered by performance and regulatory concerns; a revival of private MBS is in turn necessary for a broad recovery in housing, as well as a reduced government presence in mortgage finance.
Whatever the program's intentions, it is wrong to believe that the GSEs would not be financially damaged by the proposed program, since they still own billions in non-agency bonds purchased from 2003-2007. In addition, it's not clear how municipalities would limit their acquisitions to loans backing private-label securities. If a precedent is set to appropriate underwater loans through eminent domain, there is nothing to prevent municipalities from expanding the seizures to include loans securitized by the GSEs. (Whether homeowner-aid programs should differentiate between loans held in agency and non-agency MBS is a separate discussion.) If this occurs, the GSEs will ultimately suffer losses, which will be absorbed by taxpayers. Moreover, banks and investors holding agency MBS would also be exposed to potentially large prepayment-related losses, since seized loans would be bought out of agency pools at par.
Ultimately, the benefits to homeowners from the proposed program will be more than offset by its unintended consequences on the mortgage and housing markets. The creation of a new source of unpredictable locale-based prepayment exposure will weigh on mortgage and MBS prices, putting broad upward pressure on mortgage rates. Investors will also avoid loans originated in areas where eminent domain powers have been used, or otherwise charge substantial fees to compensate for the incremental risks associated with these loans. This will increasingly starve those areas of affordable mortgage capital and put renewed pressure on housing values, the opposite of what the program's proponents seek.
I believe that unrealistically tight mortgage credit remains an impediment to a broad recovery in home prices. (Just last week, Fannie Mae announced a significant tightening of underwriting guidelines, particularly for self-employed borrowers.) In addition to damaging the overall mortgage market, imposing principal write-downs through the eminent domain process will serve to further impair lending in troubled areas, pressuring home prices and hurting the very borrowers the proposal is intended to aid. Supporting home prices by broadening the availability of mortgage credit remains the best way to help underwater borrowers.
Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently- released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is bill_berliner@manhattancapitalmarkets.com.
