Say your neighbor Joe wants to borrow $1,000 from you. He’s willing to provide security for the note in the form of his car, and will even sign a promissory note that is his personal guarantee, pledging all he has in order to pay up. You and Joe come to terms on interest, and a deal is done.
But a few payments in, Joe stops sending you money.
You call him out on it and point out that he owes you these funds or you can legally take his car… and by the way, he has made a personal guarantee on the note.
Then you get a call from the Mayor of your town. It turns out the Mayor has heard about this private deal and that Joe isn’t paying what he owes. You might find it odd that the Mayor is involved, but you might also be comforted to know that other people will show up to encourage Joe to pay his debts.
You’d be wrong.
In this instance, the Mayor is worried that if Joe loses his car, then he won’t be able to make it to work. This might jeopardize Joe’s employment and could even lead to Joe paying less in taxes.
With less income, Joe will support fewer businesses in town.
By paying less in taxes, Joe is causing the city to fall behind on its revenue goals. This is very concerning to the Mayor, so he wants you to cut Joe’s note in half. It’s obvious Joe’s not good for entire amount anyway, so you might as well reduce the value of the note so that Joe can once again become current and everyone will be happy.
Everyone except you, of course, because you will lose half the money you lent to Joe.
So you choose not to. If by some stroke of luck Joe starts earning more money, you might actually get back what he owes you. And you could always take his car and try to recoup your money that way.
This displeases the Mayor, so he threatens to sue you. His goal is to compel you to sell the city the note for 50% of its value, thereby hanging you with the loss.
How on earth can the Mayor do this? By claiming imminent domain, and that reducing the value of Joe’s note by 50% is in the public good.
Welcome to the newest iteration of the mortgage mess.
Several cities on the West coast are contemplating this exact sort of process. Their goal is to confiscate, through imminent domain, the notes on underwater homes by paying the current note holders less than face value.
This leaves the loss with the current lender, and sounds like a fabulous way to fix the mortgage problems facing millions of homeowners… except for one thing. It flies in the face of contract law and the defense of private property, two principles on which most everything we do in the U.S. is based.
The lenders, who would be forced to eat losses in this scenario, did not force borrowers to take on mortgages. They don’t stand to profit from any gains a borrower might realize on the property purchased. They simply offered credit to willing buyers.
This is not a defense of banks. I’m not shy about expressing my utter disdain for a lot of banks and how they did – and continue to do – business. If a bankster broke the law, he should be punished. If they’re gumming up the works by holding up modifications, throw them in jail.
But the reality is most of these mortgages are not held by banks. Instead they’re held by pension funds and trust funds as parts of large pools of mortgages.
What exactly did a pensioner in Indiana, whose pension fund happens to own a mortgage-backed bond that contains properties in California, do that should make him the bearer of forced losses?
The groups that are pushing this approach have many good reasons for doing so. Most of the homes they’re targeting would be in foreclosure eventually, where lenders get even less money.
The process for servicing mortgages makes it impossible to get a clear representative for the lender, mainly because the loan has been broken into pieces and sold to many different people, so there is no way to negotiate with the other side.
The homes, if they’re empty, become a blight on the neighborhood.
Financially-troubled homeowners are trapped between two impossible choices: Keep paying for a losing asset or walk away and risk credit destruction.
These all make sense, but they are trumped by one thing. This is private property that involves a willing agreement between two parties. Each borrower took on a loan and promised his full faith and credit to repay it, along with pledging the property as collateral.
And this isn’t like one homeowner stopping the construction of a freeway. This is actually the reverse. Instead of one home, or one contract, this is hundreds and thousands of contracts that would have to be seized, all in the name of serving a large, undefinable purpose.
If such a thing were to happen, how could it be limited?
If the public good is an amorphous cloud of betterment for society, then any and all contracts, personal property, and even lifestyle choices are on the table. Local governments would gain the right to mandate or prohibit whatever they felt served us all, and leave financial losses at the feet of whatever party they choose.
The risks here are clear… and getting bigger. While this imminent domain fight is taking place out west, the CFPB (Consumer Financial Protection Bureau) is busy writing regulations in DC that will require anyone lending money to verify that the borrower is in a comfortable position to take on a loan, or else the lender can be held responsible for failure to repay.
If you own part of a bank, invest in banks, or have any dealings with the extension of credit, be forewarned. The years to come look fraught with danger as regulations and litigation overwhelmingly turn in favor of the non-paying borrower.
Ahead of the Curve with Adam O’Dell
Despite the muddying of legal matters that threaten to add risk-premium costs to future mortgages, the industry’s massive shakeup has created opportunities for investors.