Matt Levine has an interesting take on the Richmond, California eminent domain spat. He uses the conventional model which is floating around of a $300,000 mortgage on a house worth $200,000 and asks the question, “What’s the mortgage worth.” If it’s $300,000 as the mortgage owners contend then assuming they can take it via eminent domain the owners are owed compensation and if it’s worth $200,000 they obviously aren’t entitled to anything.
He looks at the problem and sees an embedded option in the mortgage. The owner can put the house back to the mortgage holder at the market price of the house; therefore the value of the mortgage is worth no more than the house. Life, unfortunately, is more complicated.
Now this is obviously wrong as you can tell from the dispute over the empirical answer; if the value of the mortgage were really capped at $200,000 then why would it trade for more? Or you can look at other embedded options in mortgages and see how they’re valued; the answer is not “they’re valued as options.” A 6% BBB-rated non-callable corporate bond with five years to maturity should be worth about 115 today; that same bond if callable at par should be worth par. And so: it will normally trade at around par.5 Freely prepayable mortgage-backed securities with above-market coupons trade above par all the time6; mortgage traders talk about “prepayment speeds” – basically the percentage of people who will rationally exercise their options – rather than just saying “well, they can prepay at par, so why would I pay above par?” The percentage of people who do not rationally exercise their options is large.
Or you can tell even more simply by the fact that these are performing loans, meaning that their borrowers keep making their monthly payments. If the homeowners were going to put back the mortgage to the bank because its principal amount was higher than the value of the house, they’d have already done so. You can see why Richmond is pioneering this plan and not, say, Hyde Park.
Viewed from this angle it’s a bit more of an intriguing problem. It seems less a cut and dried case of a city teaming up with a group of politically connected deal guys to score political points and make a quick profit at the expense of mortgage investors and possibly a case of those investors holding securities subject to and unprotected from changing economic and political circumstances. Mr. Levine sums up his thoughts:
Does it? What do the mortgage investors deserve to be compensated for: their rights under the mortgage contract, which are basically “the house or the mortgage, whichever is less,” or their expectations based on the world as it currently exists, where performing underwater mortgages trade above the collateral value because everyone knows that those borrowers aren’t just going to walk away from their mortgage? That strikes me as an intriguing question of constitutional law,8 and a delightful question of option valuation. If you valued the non-recourse walk-away option in these mortgages as a genuine Black-Scholes option, you were a fool: it was never that. But if you valued it based on historical likelihood of homeowners actually walking away from these mortgages, Richmond may yet make you look like a fool. I wouldn’t count on it, but just the fact that they raised the question should make people nervous.9
Let me offer a few thoughts and preface them by noting that I find myself still opposed to Richmond’s plan but less certain that it won’t prevail in the courts.
First, one of the comments on the Deal Breaker piece noted that the homeowner’s option actually has a premium which the example fails to include. Specifically, the homeowner is subject to the cost of moving as well as diminished credit availability if he exercises the option. While true, the Richmond plan lifts that burden from the homeowner and may or may not extinguish it entirely.
In order to provide for the costs of the program as well as provide a profit to the promoters (and Richmond as well?) the city would be required to buy the mortgages not at the market value of $200,000 but at some discount. That seems to me to be problematic and diminishes the option value argument, though it might not be fatal.
Megan McArdle points out that Fannie (FNMA) and Freddie’s (FMCC) regulator has said that it,“…would instruct Fannie and Freddie to ‘limit, restrict or cease business activities’ in any jurisdiction using eminent domain to seize mortgages.” She reads this as the death knell for the program. I read it as a threat that is totally subject to revision based on political pressure and there are some hitters heavy enough in this deal to wield that pressure. Besides, do you really think that F&F are going to draw a big “Red Line” around Richmond? It’s a threat and might cause people to think twice but I’m not sure it’s game over.
That homeowners don’t exercise their put option more often and consequently mortgages trade as if they weren’t callable bonds has little to do with ignorance of financial theory. A large and probably very large percentage of the people who buy houses do so in order to provide shelter for themselves and their families. They stick with the house through the ups and downs of market value because they eventually want to own the house outright. Say whatever you like about rational behavior to them their overriding concern is for security not immediate financial gain. Paying off the mortgage and having an unencumbered home for retirement is the goal. Valuing a mortgage has to take that behavior into account, and when you do so the argument that using eminent domain to take the paper at a price equal to the house loses a lot of its strength.
Fortunately, the Richmond plan is not likely to succeed. There are some pretty powerful forces aligning against it, though it isn’t without political support. Richmond along with strong arm tactics to force modifications, the banks’ less than stellar record servicing loans throughout the crisis and continuing though somewhat diminished efforts to force mortgage investors to write-down to market the value of their investments, will not go unnoticed in the market. Risks which previously have not been assumed to exist will certainly be reflected in pricing if and when the government pulls its subsidized lending.
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