BofA Legal Woes; Primer on Eminent Domain, Its Tax Consequences, and its Lawsuits

By: Rob Chrisman • Fri, Aug 9 2013, 9:57 AM

Those in the lending industry are more concerned with the future, but we (along with the public, regulators, Congress, and so on) continue to be reminded that the recent past has been very good for the business. For example, Radian Group Inc. said that July was its biggest month ever. All MI companies have been doing pretty well, and in this case Radian insured $5.3 billion worth of home mortgages in July, 58 percent more than July 2013 and five times more than the low in 2010 of $959 million.

And to add to Freddie Mac's profits, Fannie Mae reported second-quarter profit of $10.1 billion, about half from earnings and half from reducing loan loss reserves, nearly double what it earned a year ago. Watch for some good letters in tomorrow's commentary, but Fannie has now paid the government about $95 billion in dividends through the quarter and plans to make another payment of $10.2 billion by September. The quarterly profit was Fannie's sixth in a row, Freddie's seventh. Under terms of F&F's deal with the U.S. Treasury, their payments do not reduce the government's control over the agencies or affect the government's right to claim all of F&F's net income in the future and prevent its revival as a shareholder-owned company, the Treasury Department said last August.

Well, this commentary hasn't mentioned a lawsuit in at least 24 hours. But word came this week that the U.S. Justice Department is suing Bank of America, accusing the bank of defrauding investors by vastly understating the risks of the mortgages backing $855 million in securities. According to one source, the SEC has accused mortgage brokers of originating the majority of the bad loans that went into the BofA mortgage-backed security deal, and the SEC's action came Tuesday. Yet the latest litigation centers on Bank of America's own homegrown mortgage operations - in this case prime jumbo mortgages from 2007. "Under pressure to generate profits, the lawsuit said, Bank of America pushed employees to churn through mortgage evaluations. The instructions for slipshod standards emanated from the upper echelons of the bank, the lawsuit said." Bank of America misrepresented the quality of the loans, and five investors lost about $100 million, the government said. But BofA says that, "These were prime mortgages sold to sophisticated investors who had ample access to the underlying data and we will demonstrate that." At the time, Bank of America's chief executive, Kenneth D. Lewis, described loans that came through such wholesale channels as "toxic waste," according to the lawsuit.

I like to start most evenings off by unwinding with a glass of red, followed by briefing my cat Myrtle with what's new in the world of eminent domain - there has been a lot of posturing lately. As she and I recently discussed, the Securities Industry and Financial Markets Association (SIFMA) along with the Mortgage Bankers Association said they support efforts to reintroduce legislation that would rein in municipalities' ability to seize mortgages through the use of eminent domain. This was (coincidently?) followed by U.S. Rep. John Campbell's reintroduction of just such a bill. The proposed Defending American Taxpayers from Abusive Government Takings Act is "aimed at stopping city and county governments from enacting profit-making schemes that seek to cash in on the plight of underwater homeowners through the arbitrary seizure of private home loans. It would also prevent Fannie Mae and Freddie Mac from buying any home loans seized by eminent domain," wrote The Press-Enterprise. Rep. Campbell claims to be pressing for passage based on grounds that the proponents of the eminent domain schemes intend to use tax dollars to seize distressed home loans to fund "unconventional" loan modifications and partner with the governments to make a profit in some of the most vulnerable areas of the country. That got Myrtle's attention real fast, I can tell you!

K&L Gates writes, "Title issues that arise by virtue of the controversial use of eminent domain could impair the sale or insurance of residential mortgage loans but have received scant attention. A city seizes "underwater" loans through eminent domain, waves its magic wand, says Abracadabra or Bibbidi Bobbidi Boo, and then the mortgage lien of the prior loan holder evaporates into thin air. The city is free to write down loan principal and, for a fee, arrange for private interests to refinance the no longer underwater loan for a grateful borrower," or are they? In a perfect world, 'yes', however, as the article illustrates, it's not a simple process; a process that the courts will ultimately resolve, as well as the legality of eminent domain.

One can't ignore eminent domain. Practically everyone in the industry is against it, except its promoter the Mortgage Resolution Partners LLC. Places like El Monte or Richmond, California, or North Las Vegas, are considering using eminent domain as a means to refinance home mortgages that are underwater. SIFMA and other financial-services industry groups say that is a "bad idea" that would hurt people whose retirement plans are invested in mortgage securities, as well as harm the housing market. The securities market is very much against it.

At least a dozen cities, still dealing with the fallout of the housing bust, are studying proposals to confiscate home loans and write them down to help homeowners escape oversized debt burdens. Pacific Investment Management Co., the manager of the world's largest bond fund that's known as Pimco, is among a group of mortgage-securities investors organizing a coalition to take legal action to oppose the push, according to three people with knowledge of the discussions. Here is what the public is seeing.

And Tony B. sent along an article regarding the tax consequences.

The latest news this week comes from the FHFA, which conserves (isn't that what a conservator does?) Freddie & Fannie, threatening to choke off mortgage lending in cities that use eminent domain to seize underwater loans from lenders. "The salvo from the Federal Housing Finance Agency came Thursday, on the heels of a lawsuit directed by major Wall Street firms and U.S.-sponsored mortgage giants Fannie Mae and Freddie Mac against the Bay Area city of Richmond. Richmond wants to require lenders and investors to sell underwater mortgages at a deep discount. The city would then refinance borrowers into more-affordable mortgages. The FHFA announced it would instruct Fannie and Freddie to "limit, restrict or cease business activities" in any jurisdiction using eminent domain to seize mortgages. I would call that a big stick.

But, "What is the big deal about eminent domain?" Yes, it is "only" going after private label (like jumbo, or non-agency) loans, but there is a concern that it would soon spread to agency securities - and what investor wants to own a security whose value might go down chunk by chunk? Recall that several months ago a NY Fed paper proposed an eminent domain solution to underwater mortgages. Cornell's Robert Hockett wrote the paper, which calls on some level of government to fix "market failures" of private-label securitizations and allow eminent domain to be used to seize and/or write down creditors' claims on underwater borrowers. The Cornell academic noted that, "It is doubtful many homebuyers during the bubble years had much choice when it came to buying overvalued homes...a moral hazard can be prevented as it is easy to formulate criteria that doesn't encourage strategic defaults. Key points included, "Little need to fear" resultant long-term contraction in liquidity or credit as bubbles can only inflate during times of easy credit availability; we want "credit-caution" going forward, write downs are done "all the time" on non-mortgage debt via bankruptcy, preventing foreclosures, blight, revenue losses, service cutbacks "is recognized by courts" as justification for invoking eminent domain, and political authorities use compulsion to take property for public use "all the time."

Mortgage Resolution Partners is a Northern California firm led by Steven Gluckstern. He is a former insurance executive, ex-New York Islanders co-owner, and member of the national finance committee for President Barack Obama's 2008 election. The theory is that the plan is a means to help borrowers reduce loan balances in cases where the remaining mortgage payments are more than the homes are worth. In the past, eminent domain allowed a government to forcibly acquire property that is then reused in a way considered good for the public-new housing, roads, shopping centers and the like. Owners of the properties are entitled to compensation, which is usually determined by a court. Instead of tearing down property, MRP is trying to persuade cities to put eminent domain to a highly unorthodox use to keep people in their homes. The cities would acquire underwater mortgages from investors and cut the loan principal to match the current property value. Then, they would resell the reduced mortgages to new investors, possibly using loans backed by federal agencies, with MRP collecting a fee.

Mortgage investors say the eminent-domain tactic, which targets loans that are current, does nothing to help borrowers who most need help. They also say the program works only if judges assign a price to loans that are below their market value. "What investor in their right mind would ever invest money in a community where you could get wiped out like that?" said David Stevens, chief executive of the Mortgage Bankers Association. "The people who are going to pay the costs for this are the communities duped into this idea."

All continues to be quiet in the markets, as expected, with Europe on holiday, a good chunk of the U.S. doing the same, no economic news here, and Congress out for the month. The reports show the Fed still buying over $3 billion per day, and originators selling a little over $1 billion per day. Thursday the 10-yr closed at a yield of 2.59% - very close to that 2.60% that it's been hovering around all week. In fact, this morning it is at 2.60 and MBS prices are roughly unchanged.