Underwater Mortgages, Drowning Cities, and Rogue Financiers

08/06/2013 06:07 pm ET | Updated Oct 06, 2013

For six years and counting, multiple local foreclosure crises have brought relentlessly worsening blight, growing numbers of abandoned neighborhoods, and rapidly proliferating municipal bankruptcies to America's cities. So this week, the city of Richmond, Calif., will be the first of what will ultimately be many cities to begin taking bold steps to reverse their foreclosure crises. Richmond and those that follow will be using a novel tool -- their power of eminent domain. And if the reaction of some of the more disreputable financial "services" industry groups is any gauge, it appears to be a very promising approach, one that accordingly will soon be adopted by cities across the country.

The imminent effort by Richmond and other cities to reverse their foreclosure tragedies -- a strategy that has been in the planning for several years now -- proceeds in the knowledge that the nation's foreclosure crisis is in the first instance a local crisis, with communities of color and particularly hard-hit cities in the "sun," "sand," and "rustbelt" states accounting for the great bulk of the problem. This is so even while the problem in aggregate continues to constitute what is by far the principal drag upon U.S. economic recovery.

The source of the cities' and the nation's problems, as by this point is well known, is a veritable "perfect storm" of structural and contractual barriers to efficient creditor- and debtor-friendly modifications to underwater mortgage loans held in private label securitization (PLS) trusts. These barriers, which as a legal matter can only be sidestepped by use of governments' eminent domain authority, prevent loan modifications that will benefit bondholders, homeowners, and their communities alike.

Because these dysfunctional PLS arrangements are the key to their crises, American cities are now planning to purchase underwater loans out of PLS trusts under their eminent domain authority, write-down principal on the same, and thereby keep homeowners in their homes and communities intact. In so doing, they will be recouping lost value for investors in PLS trusts too, since needlessly defaulting loans and attendant foreclosure costs siphon-off value.

In the face of the plans just described, certain rogue elements of the mortgage securitization industry, who brought us the dysfunctional PLS arrangements just noted and in so doing bilked homeowners and investors alike in bringing on the mortgage loan bubble and bust, have predictably taken to extending their sharp practices into a new sphere. The reference here is to groups like the Association of Morgtgage Investors (AMI), the Mortgage Bankers Association (MBA), and allied industry groups -- and to their current efforts to slander the movement, threaten the hard-hit cities that join it, and capture those instrumentalities of the federal government that might otherwise assist it.

To begin with the slander, the rogue securitizers have spent literally millions of dollars on robo-calling and mailer campaigns falsely "informing" local homeowners that the plan is for cities to "take their homes" rather than purchase and write down the loans on those homes. They have spent similar sums in campaigns falsely "informing" investors that the plan is simply (a) to "take" rather than purchase underwater loans, (b) to "take" only "performing" loans, and (c) subsequently to "give" the loans to different, crony investors. Literally every one of these claims is an intentional falsehood. So is the oft-repeated claim that one and only one firm -- the for-profit community advisory firm MRP -- is "putting cities up to this."

Turning to threats to the cities, the rogue securitizers' action thus far has taken two forms, one faux-financial and the other faux-legal. In the first case, one "predicts," as the Securities Industry and Financial Market Association (SIFMA) has done now for over a year, that mortgage credit to now hard-hit cities will "dry up" if they employ their eminent domain authority to clean up the mess still remaining after the securitizers' last predatory lending binge. The most obvious problem with this claim is that when an entity controls the flow of (private) mortgage credit as does SIFMA, a "prediction" is not a prediction, but a threat. In this case the threat is to violate both the antitrust and the fair lending laws.

The faux-legal threat to which the rogue securitizers are resorting is that to "tie cities up in expensive litigation" should they make use of their eminent domain authority -- a threat the securitizers attempt to make credible by retaining high-end law firms to publicize ersatz-"memoranda." A typical example is SIFMA's "memorandum" from O'Melveny & Myers highlighting a putative Contract Clause violation, which leaves out any mention of the leading Supreme Court decisions under the Clause -- notably Midkiff, which expressly holds that the Clause does not constrain municipal eminent domain authority at all. Lawyers of this stature do not forget Midkiff. Rather, they hide it, in hopes of intimidating city attorneys out of doing what their cities both must and may do.

Turning next to the capture of federal instrumentalities, the rogue securitizers have for the past year been attempting to bully the Federal Housing Administration (FHA), the Federal Home Finance Agency (FHFA), and the Department of Housing and Urban Development (HUD) into expanding the industry's threatened private credit boycott into a full public boycott as well. At the same time, they have attempted to hector the Federal Reserve Board, the Treasury Department, and the White House into joining them in bullying the aforementioned agencies. Finally, in a crowning glory, three Republican members of the House of Representatives, who receive most of their campaign funds from the same securitizers as brought us our crisis and now bully the cities and federal agencies, have even introduced an Orwellianly named bill aimed at legislating what the industry is unable to lie and coerce into happening.

Enough is enough. Our nation's unique system of mortgage finance, pioneered by the late Hoover and early Roosevelt administrations in the wake of our last real estate crisis, was a marvel of ingenuity and public-private collaboration. In the course of a mere 30 years, it brought us mortgage insurance, the 30-year fixed-rate mortgage, the secondary mortgage market, and a homeownership rate of near 70 percent after centuries of rates below 40 percent -- assisting the growth of a robust and asset-owning American middle class.

This system functioned smoothly, stably, and efficiently for more than 60 years to the late 1990s, when rogue securitizers looking for a quick buck, aided by a new industry of unregulated mortgage originators, began "privatizing" the primary and secondary markets with pump-and-dump mortgage schemes disproportionately targeting elderly Americans and communities of color. These middleman schemes defrauded borrowers and investors alike, and thus far only the victims, the taxpayer, and their cities have paid.

Now the same industry that left all these victims, fearful that success among cities in ending their crises will expose the role of their sloppy and often fraudulent PLS arrangements in manufacturing and perpetuating these crises, are doing all in their power to ensure that the cities do not solve them. This is not merely "tragic," it is a national outrage.

What, then, to do about it? All Americans should respectfully ask Congress not to allow the securitizers to succeed in this community-destroying and nation-impoverishing effort. They should demand that Congress restore the system of mortgage finance that this nation enjoyed until the late 1990s, that it exclude the rogue securitization industry from any further involvement in this system, and that it enact legislation prohibiting this industry from any further attempts at blackmailing the nation's cities out of cleaning up the mess with which the securitizers have left us.

Robert Hockett is a Professor of Law at Cornell University, a Fellow of The Century Foundation, and a regular consultant to a number of legislators, regulators, and municipal governments. With several others, he has been designing and advocating eminent domain plans for underwater mortgage loans and related financial instruments since the onset of crisis in 2007-08.