But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
Eminent domain is an aggressive proposal by state and local governments to encourage principal modifications
The idea for Eminent Domain started in San Bernardino, California, to solve the problem of underwater homeowners. The idea was that underwater homeowners were depressing the economy, and that the way to improve the economy was to reduce the principal owed on their mortgages. However, a local government can’t compel an investor (such as a mortgage REIT) to forgive a principal, and the servicer, who handles the actual negotiations, has a fiduciary duty to the investor.
Eminent domain is a way for a government to seize someone’s property for the collective good. Think of a proposed freeway overpass that would go through a neighborhood. The government would use eminent domain laws to force local residents to sell their properties to the government so that the government could build the freeway.
How the eminent domain idea applies eminent domain laws to mortgages
San Bernardino came up with a novel twist on the idea: to use eminent domain to seize underwater mortgages by forcibly taking them from the investor at “fair value” and then having the government reduce the principal on the mortgage. Here’s how the plan would work. Suppose someone has a $200,000 mortgage on a $100,000 house. The government would take the mortgage from a REIT investor, pay the investor a sum below the house value—say, $85,000—and sell the mortgage to a hedge fund. The hedge fund would then refinance the mortgage at $100,000, sell it into a To-Be-Announced security (TBA), and split the $15,000 profit with the county government.
Needless to say, this practice is at best legally questionable, and many experts have found the idea unconstitutional. San Bernardino eventually rejected the idea after the Securities and Financial Markets Association (SIFMA), which runs the TBA mortgage market, declared that mortgages from San Bernardino County would be ineligible for inclusion into TBA securities if the county followed through with its plan. This would basically make San Bernardino loans un-securitizable, which means the county would be cut off from conforming and government loans. Given that 90% of mortgages are either conforming or government, this would effectively eliminate mortgage availability in San Bernardino.
Richmond, California, votes to go ahead with the eminent domain solution
The city of Richmond voted to use eminent domain as a tool to force bondholders to sell mortgage-backed securities to their partner hedge fund at a discount to appraised value. So far, we have yet to hear from SIFMA, although it’s likely it will cut off the locality from the TBA market if the city follows through.
Implications for mortgage REITs
How this plan would affect conforming and government mortgages is an open question, because the government guarantees principal and interest payments. Such a plan would cause a big bill for the Federal Government, and would cause (at best) increased prepayments for agency REITs like Annaly (NLY), American Capital (AGNC), and MFA Financial (MFA). Non-agency REITs, on the other hand, would take heavy losses, as a mortgage that is marked at $200,000 would sell for $85,000. This would be a huge negative for a company like PennyMac (PMT) or Chimera (CIM).
© 2013 Market Realist, Inc.