Eminent Domain Spells Trouble for Banks

 | Jun 11, 2013 | 11:22 AM EDT  | Comments
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he federal and state governments are now focusing increasing attention on the issue of non-performing residential mortgages being held by the money centers that are not being sent through recovery.

About 70% of all bank-held non-performing mortgages are concentrated in the money centers: Bank of America (BAC), Wells Fargo (WFC), JPMorgan Chase (JPM) and Citigroup (C ).    

I've written many columns in the past few years concerning the issue of the money centers not addressing their non-performing mortgage loans. The issue is truly daunting and has changed little since I reviewed some of the numbers in May.

Last month, the Federal Housing Finance Agency (FHFA) and the U.S. Department of Housing and Urban Development (HUD), issued a report on the issue.

On the federal side I wrote two columns in March (here and here) about the FHFA's plan to allow banks to refinance the Fannie/Freddie mortgages they own that are in default.

There's been no news yet as to how the banks are going to handle this.

Concurrent with the FHFA's announcement there's been a state push to address the issue that was first begun in California by the firm Mortgage Resolution Partners to use eminent domain to condemn the defaulted mortgages, pay the banks fair market value for them, refinance the defaulted loans for the existing mortgagors and then resell the loans to Fannie and Freddie. 

The Federal Reserve Bank of New York also just published a paper on the subject of the use of eminent domain for mortgages signalling federal regulatory support for the states to proceed.

These are both methods for encouraging the banks to address this issue and given the fact that home price appreciation has now accelerated to a rate in excess of income growth, as I wrote about earlier this month, the urgency to resolve the issue is only going to grow from here.

The federal initiative may be considered a regulatory, pull-through, honey kind of offering, while the state initiative is a legislative, push through, vinegar attempt. 

The fact that the banks have refused to deal with the issue and their regulators, most importantly the Federal Reserve, have been unsuccessful in encouraging them to do so, has forced the other regulators and state governments to step in.

The legislative push to use eminent domain is increasing, beginning to gain political traction, and is probably one of the motivations behind the FHFA's decision to offer the streamlined modification initiative for defaulted mortgagors.

Regardless of how this plays out, the issue of addressing and resolving the nonperforming mortgage problem is coming to a head and how it is finally resolved has enormous consequences for the money centers, home builders, housing and the economy in general.

Until recently, the use of eminent domain was considered to be improbable legally. The fact that the banks, most specifically the money centers, have decided to not address the issue and have allowed loans to remain in default for several months to several years now raised the legal and political issue of abandonment. So, it needs to be taken seriously.

The fact that the initiative began in California is also important. One of the derivatives of "as goes housing, so goes the U.S. economy" is "as goes California housing, so goes U.S. housing".

Booms and busts in California housing are both earlier and larger than anywhere else in the U.S. It is also where all financial engineering with respect to mortgage products come from. It was the birthplace of the no-income verification loans (NIV) as created by World Savings in the 1980s, from which every other subprime product was derived and first made available in the state.

If the state of California and Mortgage Resolution Partners are successful in implementing eminent domain on abandoned mortgages there, it will undoubtedly be adopted by other states quickly.    

The most important issue for investors in the money centers to be aware of is that this could cause loan losses to have to be booked and accounted for in a very short period of time, with those losses being well in excess of loan loss reserves.         

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