Financing the Refinancing: Federal Money, Private Money, or Both
But how are states or their sub-units to pay for the loans or the liens, given that the foreclosure crisis has left them more cash-strapped than the federal government? Here is how: One possibility is to finance the purchases with monies lent by federal agencies in the manner of the Treasury’s Troubled Asset Relief and Public-Private Investment Programs, and the Federal Reserve Bank of New York’s MBS stabilization programs, all of which ultimately have turned profits. Alternatively, they might use monies provided by private investors, or monies from both federal agencies and private sources. The federal agencies or private investors then can be paid from the proceeds of the refinanced and accordingly more valuable loans, or in bonds issued against pools of the same.
If private money is used, then the investors both can and ought to include current bondholders, who might receive warrants before federal or private investors are brought in. This approach respects bondholder interests and underscores the sense in which the eminent domain plan is meant simply to solve a collective action problem that dysfunctional pooling and servicing agreements prevent trustees and servicers from solving themselves on behalf of their bondholder beneficiaries.
By working with states or municipalities in this manner, current bondholders would piggyback on governmental authority to sidestep the contracts that currently preclude their doing what portfolio lenders already do. To note that these participating bondholders will be “paying themselves” less than face value would just be a roundabout way of saying that they are writing down principal.
The diagram above presents a schematic rendering of the eminent domain plan. The diagram, which should be read counterclockwise, shows investors, including current bondholders and perhaps federal agencies, conveying funds to eminent domain trusts operated by the states or their subunits. These eminent domain trusts then purchase deeply underwater (“bad”) loans from private-label securitization trusts. The states or their sub-units, in most cases probably advised or otherwise assisted by financial professionals, then work with homeowners to write new mortgages, replacing the negative equity loans with modestly positive equity loans—probably thirty-year fixed-rate mortgages in all cases.11 Finally, the new (“good”) loans are conveyed to the first-mentioned trusts, which convey the resultant funds to the first-mentioned investors.
The payouts will in most cases take the form that payouts on the earlier, unmodified loans took—bond yields to bondholders. And, as noted earlier, the new bondholders should include as many of the original bondholders as wish to participate, since the aim of the plan is to enable homeowners and bondholders to do what the pooling and servicing agreements now prevent them from doing—modifying underwater loans to recoup presently lost value.
The sequence of steps depicted in the diagram provides only the broad outline of the plan. More is required to render any particular variation operational. There are, for example, the matters of (a) selecting and valuing appropriate loans; (b) securing government and/or private investors, if any; (c) commencing the legal proceedings necessary to exercise eminent domain authority; (d) modifying and possibly re-securitizing the loans once purchased; (e) working with homeowners throughout the foregoing; and (f ) compensating investors at appropriate stages.
All of these actions can be managed in various ways (Hockett 2012a). Briefly, on (a), the guiding criterion should be whether the loans’ expected value can be raised sufficiently to offset the write-downs and associated transaction costs. A variation on this criterion, where public money is available to supplement private money, might be to include loans whose expected-value improvements fall slightly short of offsetting the write-downs and associated transaction costs, in light of the foreclosure externalities that write-downs will avoid.
On (b), if federal and subfederal units of government find merit in the plan, they can approach one another to arrange lending from the former to the latter. Either can also approach existing bondholders or other investors if desired.
On (c), states or their sub-units will commence the proceedings and courts will conduct them. In the “quick take” proceedings available in most states, the taking authority places the estimated value of the loans plus some margin in escrow when filing, explains the basis of its valuations to the court’s satisfaction, then takes title. Subsequent litigation, if any, concerns only whether more should be paid, not whether the taking can proceed. In most cases, governments have accurately assessed the value of the loan, often with assistance from private valuation experts, and paid adequately. This bears noting in view of popular misconceptions concerning the likelihood of protracted litigation.
It should also be noted that, in view of the market failure and consequent waste stories that prompt this proposal, we can anticipate sizable pre-trial, out-of-court agreements among state or municipal governments and bondholders on loan selection and valuation criteria, particularly if relevant federal officials facilitate.
As for (d), (e), and (f ), these are primarily matters for states or municipalities to manage, albeit again with assistance from public or private financial professionals in most cases. The municipalities are best situated to approach prospective homeowner beneficiaries once qualifying loans are identified. Financial advisor y assistance, in turn— whether from a federal entity like the Federal Housing Administration, from private providers, or both—will be helpful in most cases both in restructuring loans and in arranging investor compensation.
The Plan’s Legal Basis: Taking Intangibles for Public Purpose and Paying Fair Value
How commonly is eminent domain used for more than compulsory land purchases for roads and bridges? Though non-lawyers are not always aware of the fact, governmental authorities compulsorily purchase property at fair value for public use all the time (Hockett 2012a, Section IV). And they do so with all manner of property—tangible and intangible, contractual and realty-related alike.
Forms of intangible property that have been purchased in eminent domain include bond tax exemption covenants, insurance policies, corporate equities, other contract rights, businesses as going concerns, and even sports franchises (Hockett 2012a). Because the law draws no distinctions between kinds of property that can be purchased in eminent domain, it is unsurprising that loans and liens in particular, as one form of contractual obligation among many, are themselves regularly purchased.12 Among these are mortgage loans and liens, as the Supreme Court and state courts have long recognized.13
The question, then, is not what kinds of property can be taken, but whether a public purpose justifies the taking and fair value is paid. Preventing more foreclosures, blighted properties, revenue base losses, and city service cutbacks is recognized by courts as the most compelling of public purposes justifying use of the eminent domain authority.14 As for fair value, how is this determined? Won’t municipalities have to purchase loans at less than fair value to recoup enough margin to compensate the investors, public or private, who put up the purchase money?
First, on valuation, there are multiple methods available. Where mortgage-backed securities associated with a particular loan pool or analogous pools trade at a discount, for example, imputation of counterpart discounts to underlying loans is arithmetically straightforward. And private-label securitization bonds, it bears noting, are trading at very steep discounts.
The latest data from Amherst Securities on PLS senior debt, for example, are telling, as are estimates of senior bonds as percentages of total bonds outstanding and prices thereof as percentages of unpaid principal balances (see table above).
Where bond-to-loan discount-imputation is unavailable owing to missing markets, discounted cash flow methods will do. As noted above, for example, Fannie Mae and Freddie Mac publish expected default rates for sundry classes of underwater PLS mortgages each year. From these—along with foreclosure costs, associated recovery rates (generally no more than 22 percent on defaulted loans), and discount rates—the calculation of net present values is not a recondite exercise. And our courts, which routinely hear valuation arguments in multiple contexts and often impanel experts, will oversee the proceedings as required by law, ensuring fairness to parties. Even this safeguard might be more than is necessary, however, if federally overseen valuation summits of the kind mentioned above and discussed further below should prove workable.
What about the putative need to pay current investors less than fair value to compensate new ones? Must one rob Peter to pay Paul? The answer is no. Eminent domain proceedings need not represent “zero sum games.” By averting market failures—and the needless sacrifice of value that these failures entail—the plan proposed here recoups value, which can then be equitably distributed to render all stakeholders better off.
First lienholders who help finance the purchases from their PLS trusts receive loans that are higher in expected value in exchange for loans with lower expected value. First lienholders who do not thus participate receive fair value for otherwise unmarketable assets. (This is so even if trustees in some cases must divide proceeds among subclasses.) Homeowners receive modest equity in their homes and diminished default and foreclosure risk. Neighbors see their communities, property values, and municipal services stabilized, while municipalities see property tax revenues restored and abatement costs drop. Even second lienholders can benefit if paid a small fraction of the value recouped by the write-downs, since in foreclosure they receive nothing.