Bank Lawyer's Blog

The More Things Change

Six years ago, right before the Big Bang that sunk this country's economy, we discussed problems of declining net interest margin on bank profitability, the ineffectiveness of the rate-cutting efforts of the Federal Reserve to boost that margin, and that banks were desperately seeking income from all sorts of other fees (including overdraft fees) and new lines of business to combat the problem. Over half of a decade later, the situation sounds distressingly similar.

Central Massachusetts banks are feeling the squeeze — the interest rate squeeze.

Financial performance among banks based in Worcester County during 2013 reflected the fine line institutions are facing as they grapple with slim margins while investing in technology and working to comply with new federal regulatory requirements.

"We really, over the last five to six years, have seen the net interest margin shrinking year after year," said Thomas J. O'Connor, vice president in charge of the financial institutions practice at G.T. Reilly & Co. of Milton, an accounting and consulting firm that works with community banks. "It's really the market conditions. These aren't institutions that have done anything wrong. If anything, they've done everything right."

[...]

All the banks face a common problem: Costs to manage customers' deposits while complying with federal regulations, especially reforms enacted under Dodd-Frank legislation in 2010, are steady to rising. Yet interest rates paid by borrowers taking out new loans are low.

The result is low net interest margins, or the net income that banks make charging and paying interest relative to the bank's assets. In Central Massachusetts, eight banks had net interest margins smaller than overhead costs relative to assets during 2013.

"Bank earnings are going to be suppressed until interest rates start to rise at some time in the future," said Commerce Bank President and Chief Executive Brian W. Thompson. "I don't think there's any expectation that's going to happen until sometime in 2015."

You can substitute "Central Massachusetts" with pretty much any other geographic area, and you'll have the same problem as far as the interest rate yield curve is considered.

The yield curve problems go back even further than 2008, when the world came crashing down around us. The following is from a blog post I wrote in August 2005:

The underlying economic problem for the banks is the flat yield curve. It's frankly without precedent (outside of a recession), or at least that's what my bank and hedge fund clients tell me. I defer to them on such matters, because I'm merely their mouthpiece with no mind of my own. However, assuming that this is true, banks can't make nearly enough money making conventional loans for the simple reason that the spread between what they pay to borrow the money (for example, by issuing a certificate of deposit to a consumer) and what interest rate they can charge on a loan they make with the funds borrowed, isn't enough to cover operating expenses, much less make a profit. That's the problem when the spread between two- and ten-year bonds is 20 basis points (0.02%), and the spread between two- and thirty year bonds is 40 basis points (0.04%). Thus, there has  been increasing pressure on banks to increase fee income, from whatever sources are legal.  The fees charged are legal. The banks are trying to make money. It's what they do.

Later that year, the curve became inverted.

If Mr. Thompson is correct, the interest rate squeeze will have lasted over a decade. Thus, while much has changed in the world of banking in the last nine years, banks find themselves in a distressingly similar place today: trying to make a buck from sources other than interest rate spread. They are trying to do so while coping with a post-Dodd-Frank world in which the elephant in the room, the CFPB, sets the tone for vigorous opposition to "taking advantage" of "fog-brained consumers" who don't have a clue what's in their own interests. "Taking advantage" means "making any money from banking services provided to." Thus, overdraft fees have been savaged, debit card interchange fees have been squeezed, proprietary trading hammered, and "subprime," "payday," "tax refund anticipation," and "deposit advance" all have been rendered to be four-letter words by the federal banking regulators.

The future sure looks rosy, doesn't it?

Bad Banking!

My friend and occasional guest blogger Pat Dalrymple, a former community banker, felt the need to blow off steam again, so I'm indulging him. Actually, he's a lot more optimistic than I am, but that doesn't take much.

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The smart money today is emphatic in advising not to get into banking as a buyer of, or  controlling investor in, a financial institution, especially in a smaller, so-called “community bank”..

The reasons cited are many and cogent:

·         Regulatory restrictions are choking off profitability.

·         There’s a dearth of acceptable assets for investment to soak up the deluge of cash deposits flowing into banks.

·         The Dodd-Frank Act has triggered regulations that make compliance difficult, complex, expensive, and virtually impossible to accomplish.

·         Appreciation in a bank’s market value is minuscule, compared to the windfalls that investors experienced over the past 40 years.

·         Big bank competition makes it impossible for a small bank to thrive

·         The quality of small bank loan portfolios is suspect.

·         Banking isn’t fun anymore.

There are others, but you get the picture.

In fact, every one of the above is true.

Yet, if we’ve learned anything in the last 5,000 years or so of recorded history about war and commerce, when the experts say “do”, don’t.  When the word is “don’t”, seriously consider doing the opposite.

Airplanes could never sink a battleship, submarines were nothing more than toys.  Why would anyone invest in a flying machine, a horseless carriage, or a device that lets people talk on wires?’’

In this instance, we’re not talking about buying stock in a mega-bank.  That’s probably a pretty good bet over the long haul, because the big banks almost can’t help but make money, positioned as they are at the crossroads of global industry and commerce.  The opportunity, if there is one, lies with little banks in relatively small markets: the institutions under, say, $200 million.

Big banking and little banking are two almost completely different businesses that, paradoxically, are governed by the same set of regulations.  Inevitably, these regs are applied differently to the two industries.  Our focus here is on the smaller of the two, but, in terms of the number of individual institutions, and thus in opportunity, much the larger.

So, let’s take a quick look at all of the good reasons not to buy a bank:

Regulatory stifling of profitability:

This  maybe should be first on the list of considerations, and it has to be recognized as a challenge at the outset.  It’s absolutely a fact of modern commercial life that the regs make it difficult to make money the old fashioned way.  Most community bank business models are using pre-crisis blueprints, which may not work in a post meltdown environment.

We’re all products of our training, and bank management teams certainly weren’t conditioned to adust when the basic rules of the game changed.

So, the plan for a purchaser may have to run contrary to a lot of conventional wisdom to thrive in the current economic ecosystem. Fore example,  if the bank isn’t already doing so, become the go to residential mortgage lender for your customers.  When the bank can’t make a loan which could ultimately result in a profitable long term relationship, (which will be often these days) find ways to assist that customer to find alternative financing.  And above all, don’t forget to make money doing it.

Also, carefully look at the cost/benefit equation of paring expenses. All banks, big and little, have been cutting costs for the past several years.  Most community bankers are convinced they’ve cut to the bone, but they’re wrong; they’re running the business that they built and were trained to run, and that model just doesn’t exist in the old format.

For example, small banks that have branches probably shouldn’t.  The deposits accumulated simply  don’t justify the cost. Paradoxically,  management has kept the branches open to “preserve the institution’s franchise value” for potential purchaser.  Ignored is the strong likelihood that, should that buyer come along, the branches will be shuttered soon after the sale closes.

Finally, in viewing a troubled bank, the income statement can tell an interesting story: when all of the expenses attendant to regulatory restrictions and undercapitalization are erased, one often finds that, even with last century’s business model, the bank can be adequately profitable.

Scarcity of good assets:

This phrase merits some redefinition:  There are a lot of quality loan assets around; they just don’t fit the regulators’ discriminatory definition of what’s good.  Of course the result doesn’t change.  If  the regulators classify the loans as second class citizens in the general population of paper, then that’s what they are.

Conventional wisdom says that a lot of bank dollars are chasing few assets, so the big fish will force the little ones out in the feeding frenzy.  But CW, as usual, may have it wrong.  Money center institutions have managed to cinch up  the regulatory bonds past even what the examiners have done to them.  This is because, in response to the post Dodd-Frank regs, they’ve instituted multiple layered internal policies that have destroyed their flexibility.  Good loans often go to big banks to die, especially if they have to move up the approval ladder.  Savvy community banks with good CAMEL ratings are using their huge edge in flexibility and processing time to take high quality business away from the bullies in the high rise offices.

Cost and complexity of compliance:

Nothing causes more angst and molar grinding among bankers than complying with the plethora of consumer laws and regs enacted and promulgated in the wake of the Great Meltdown.  But most of the wailing is done by old duffers like me that have been around banking since way back in the last century.  Fortunately for everybody, we’ll die off, to be replaced by bright young people who will grow up in an over-regulated environment and will opine, “Gee, what’s so hard about that”.  And no matter what us old cowboys tell you, it doesn’t really cost an arm and a leg to accomplish the task.

Minimal appreciation in the bank as a salable asset:

True; you can’t buy a bank and sell it three years later at 3.5 times book.  Putting equity money into a financial institution today is a longer term investment.  But the cash on cash return can be very impressive, which will very nicely enhance book and market value.

Forget about owning a little bank.  Big banks have all of the business:

No businesses are better positioned in their marketplace than community banks.  Few businesses do a worse job of exploiting that advantage.  (See the flexibility factor noted above)  Imitation is the sincerest form of flattery:  the big banks know the advantage of looking little to the home town folks, and often they’re more successful at it than their smaller brethren.

A prospective purchaser of a bank must understand the marketing plum to be acquired that very likely has been woefully underutilized.

Small bank loans are second class paper: 

True for some; at least from the new regulatory perspective.  And almost certainly so for institutions that are the prime targets for investors.  These are the troubled banks that sometimes had to be satisfied with the skim after the cream was scraped off by competitors.

However, any of these loans that are currently performing in a post-nuclear financial landscape are survivors, and have a very good chance of continuing to be.  One of the dichotomies of negotiation for a bank involves the owners touting the net interest margin of the portfolio, while the shopper counters with, “Yeah, but look at the loan quality”. Actually, the quality may be pretty good. The deals have   been through the fire and they’re still anteing up that high interest rate, which can be pretty neat for an investor.

And then there are the non-accrual loans, those gems that you can’t book income from until they go away, one way or another.

What’s weird, is that a lot of these really rotten deals are performing.

My pilot friends tell me that any landing you walk away from is a good one.  My wisest banking friends say that, in the final analysis, a good loan is one that gets paid back.  This bottom line criterion doesn’t necessarily meet 21^st century regulatory discrimination, but, in some instances, it can set up a nice little windfall for an investor, because all of that deferred interest on the loans that continue to perform will ultimately find its way to the bottom line.

That’s about it, so……….

What?  Oh yeah….having fun.  Well, if you’ve been a bank exec for more than ten years, it probably isn’t much fun.  In, say, 2004, the 3-3-3 banking rule didn’t actually prevail (you know, pay 3% for your deposits, mark your loans up 3%, and be on the golf course by 3) but it was a day on the beach compared to 2014.

On the other hand, if you can buy a clean bank, or make sure that the existing owners clean it up before handing over the keys, then you might have a pretty good time, given the potential profit margin.

Loans To The Poor: Going Postal

When the news broke recently that the US Postal Service is considering going postal on financial services, especially small dollar loans to the "under-and-un-banked," my knee-jerk reaction was the same as Cam Fine's:  "Have you ever stood in the lines at Christmastime at a post office?" I believe Cam also said it was the worst idea since the Edsel.

The proposal was floated in a white paper, and I assumed it was merely a trial balloon by the USPS. At any rate, the initial reaction of the banking industry was so negative that I also assumed that in this year of mid-term elections, partisan gridlock would assure that it was an idea that was DOA. Therefore, I didn't plan to comment on it.

However, my initial WTF? reaction was reinforced beyond a shadow of a doubt when I read last week that Princess Fauxcahontas thinks that the idea is more compelling than a vial of amyl nitrate poppers, a quart of Crisco, and Jennifer Lawrence unchained. Cutting to the chase, Liz thinks that it's unfair that the poor pay more for financial services. This fact is "unfair" according to a standard of "fairness" that has been well articulated in Das Kapital. It is the function of the federal government to rectify this "unfairness" by creating a central government-controlled lender that ensures that credit costs for the poor are "fair."

The poor pay more [for credit], and that's one of the reasons people get trapped at the bottom of the economic ladder.

The poor pay more, as a percentage of their gross monthly income, for just about everything, including food, utilities, rent, and transportation. That is why many of the poor need to borrow: they don't have enough monthly cash coming in the door to pay for the necessities of life. Many of them have a tough time paying back the principal they borrow, much less the finance charges. That's why they are considered poor credit risks and why charging them more for the credit risk they pose makes sense in a free market system.

I assume that Warren doesn't believe that the best solution to "the poverty trap" is to focus our collective efforts on creating more better paying jobs and providing an education that gives the poor skill sets to obtain and perform those jobs. Instead, based upon her world view that the real culprits here are "sky-high interest rates and tricks and traps buried in the fine print of their loan products," Warren wants to focus her (and our) efforts on taking a historically inefficient giant bureaucracy and making it the center piece for a government-controlled effort to give more loans to the poor, which I assume she believes will allow the poor to borrow their way out of the poverty trap. 

Good luck with that scheme.

Hank Paulson Lets His Hair Down

Former Secretary of the Treasury Hank Paulson (known to the Hip-Hop community as "P. Hankie") sat down recently for an interview with Dallas Business Journal reporter Nicholas Sakelaris, and gave us the low down on the bail out of the Big Banks in 2008. As you might have expected, Hank the P claims that he had no choice. It was bailout the big boys or The Apocalypse. There was no middle ground.

We had some difficult decisions. We did some things that were unpleasant, even to us. But I felt then and looking back at it now, I think we got the big things right and made a big difference. We staved off disaster.

To those who claim that the capitalist system works only when those businesses that make bad decisions are allowed to suffer "creative destruction," Hank's response seems to me to be that all that theory is fine in the ivory tower, but down on The Street (Wall Street, that is), when the rubber meets the road, the tough get going, or something along those mixed metaphorical lines.

Many, many Americans were unhappy because they wanted to hear that the people who made the mistakes were being held accountable. But if I had to decide between that and stability, I erred on the side of stability. All Americans would have been hurt if the system had collapse. Those that had been responsible and those who had been irresponsible. Those who had made mistakes and those who didn’t make mistakes.

Our first priority was to prevent catastrophe to protect the American people.

That’s hard to explain and that’s hard for the American people to really understand a catastrophe that never occurred. What they see is a very serious problem that did occur. I can say, we took steps and it would have been much worse if we hadn’t taken them and guess what, the money we put out in the TARP and the capital to banks and insurance companies came back plus $32 billion.

Hard to explain? No, I think you just explained it, Hankster, and I also think most of us catch your drift.

When asked if he, personally, could have done more to prevent the problems that led to the economic crisis that required such a massive bank bail out, Hank claims that the underlying factors were pretty well "baked" into the system by the time he was appointed in 2006. He also says something to which the FDIC might give at least a head nod when it decides whether or not to sue officers and directors of a failed bank: nobody saw anything this bad coming down the pike.

...I didn’t see something of that magnitude. I had witnessed crisis every eight to 10 years. But this is a once in a 75-year crisis. In this one, the excesses had been building for decades.

[...]

This is one that was unprecedented. People hadn’t taken a look at our regulatory system in a long time. The financial markets had outgrown the regulatory system and it didn’t fit so we didn’t have the powers we need.

A guy with Hank's pedigree and access to information didn't see this train wreck coming, but the board of directors of a half-billion dollar community bank should have anticipated it. You see the absolute logical consistency of these positions, don't you? Don't you?

[crickets chirping]

I happen to think that Hank Paulson is right on the money. The bailout prevented a catastrophe. I realize that Libertarians who read this blog get shooting pains in their lower abdomen when they read such opinions in this sector of cyberspace, but that's why the drug companies spit out analgesics.

As Hank says, it's tough to defend the position that you prevented a catastrophe that never occurred. At least, it's tough in a society where many often stake out positions and marshal the facts to support them. Following the facts wherever they actually lead takes a different mind set.

A New Game Plan

Long-time mortgage lender and banker (and old friend) Pat Dalrymple, whose guest posts have occasionally graced this blog, wrote a gem recently for his regular column in a Colorado newspaper. Pat provided a real-life example of the consequences of heightened regulatory scrutiny of commercial lending at community banks across the country. As Pat puts it, the scenario is so common that he doesn't even need to worry about the regulators figuring out which bank he might be discussing. I assume that many community bankers (and, unfortunately, many borrowers) recognize themselves.

The worst bank examiner rating for a loan is “probable loss,” which means that the bank has to write off the entire loan, taking the balance out of capital and current income. The next worst is “nonaccrual,” which means that the bank, rather than booking interest income on the loan, must apply the money received to the loan balance on the bank’s books, and realize a profit or (loss) only when the loan is paid off, or the foreclosed property is sold.

But a funny thing may have happened on the way to “nonaccrual”: the loan didn’t turn into a bad loan, it was just called bad by the regulators because, well, the rules changed between exams.

Nonaccrual loans, along with foreclosed collateral, are held to be an indication of a bank’s health. A large percentage of these problem assets in relation to an institution’s capital can mean that the bank is in trouble. However, if one digs into the makeup of these nonaccrual loans, in many cases, a surprising, even shocking, number of them are paying like clockwork. 

[...]

A business owner has been a premier customer of the a bank for, say, 15 years on both sides of the ledger, as depositor and borrower. He comes to the bank president for a relatively small increase in his business operating capital loan; a request that’s been routinely granted for years. The CEO says, “Sorry, we can’t do that. As a matter of fact, we’d like you to move your loan to another lender.”

Of course the guy is ticked off and marches out of the bank vowing never to do business with it again, while figuring that he’s the cream of the crop of bank customers; after all, hasn’t he been told that for 15 years?

Turns out, the rules have changed for everybody. The three banks he subsequently calls on tell him he and his business can’t be accommodated. He then goes back to his old banking partner and announces, “It’s just you and me kid. Looks like we’re stuck with each other.”

And so it goes. Community banks provide the lion's share of the lending to small businesses in this country and small businesses drive job creation. People wonder why the economic recovery has been so prolonged and weak. While there are many culprits, regulators making sure the last war never again breaks out is one of them.

In the meantime, the big boys are doing just fine, thanks for asking.

Blowing The Fog Away

One of the country's leading behavioral economists, Sendhil Mullainathan, who currently teaches at Harvard but was the CFPB's head of research, recently gave an interview to the American Banker's Kevin Wack, in which Professor Mullainathan made some points that concern CFPB critics like the author of this screed sheet, but also contain indications that at least some true believers in behavioral economic theory are fair minded enough to understand the dangers of pushing the envelope with any economic theory.

First, the scary part.

Mullainathan teaches at Harvard, and he is the co-author of a new book, "Scarcity," that has important implications for the consumer finance industry.

The book argues that the short-term thinking of many poor people — who worry about how to pay their immediate bills without much regard for their long-term financial outlook — is a psychological consequence of the scarcity they face. Their lack of money taxes their mental bandwidth, and leads them to a narrow, short-term way of thinking.

The book draws analogies between people who are poor, people who are extremely busy, and people who are lonely. In all three cases, people lack something they need, and it clouds their judgment.

"You might see someone who's poor go to the mall and buy something that they don't need," Mullainathan explains. "And you'd be like, 'How can somebody at the edge waste so much money?' Now, picture someone else you know who's so busy, but goes and spends hours wasting time on the Internet. And you might say: 'How could someone who's so busy end up wasting so much time?' And those are so very similar behaviors on some level."

Thus, the contention is that poor people are too dumbed-down by their lack of funds to think straight. Who'll do their thinking for them? Why, the not-so-poor people who work for the CFPB, that's who! If salary level increases brain power, then The Adjustment Bureau ought to be crawling with Einsteins.

Do you see the danger of this line of thinking? I do. Apparently, so does the intellectually honest Professor Mullainathan, at least he does while answering a question put to him by Wack.

You alluded to an argument that some conservative critics of behavioral economics have made, that this is just sort of a way to put a veneer of academic responsibility on paternalism. Do you think that's a real danger, or is it kind of a caricature of what's going on?

I think it's a real danger. I'll give you two very extreme examples. When you look at drug behavior for diabetics, that has really large consequences, when diabetics fail to take their medication. Like 100,000 limbs are lost every year because people aren't taking their meds. This is a pill with very few side effects. I mean, it's just a no-brainer.

Drinking sugary sodas? Now, that's a much harder case to make. Because soda provides some utility, and there's no doubt it has some health costs. It's easy to imagine somebody looking at that tradeoff and saying, "Fine, I'm going to live a little bit less in my life. But I love the utility. I want to drink it."

Somewhere what ends up happening is: the same principle tries to be applied to the soda case. You can see it already happening, and I think it's a legitimate concern. I think that what's a mistake is saying that because we have that legitimate concern, we shouldn't do anything.

The word "legitimate" raises the question as to whether the conclusion drawn by the economists regarding the "problem" are supportable: a shortage of money clouds the judgment of poor people. Let's assume that empirical research supports that conclusion. The next question becomes what, if anything, is the "something" that should be done about it and, assuming that there is a public policy consensus by a majority of American voters that "something" should be done, what, exactly is that "thing" and who or what should "do it." 

These are all legitimate issues to be considered and debated. Unfortunately, there doesn't seem to be much debate, at least in the political arena. Instead, there seems to be an agenda that is being pushed that it is the duty of the government, particularly the executive branch, and particularly the federal executive branch, to protect the "brain fogged" from the the consequences of their own behavior, even if the "victims" don't want that protection and even if opponents think that adult citizens need to be responsible for the consequences of their own decisions, whatever the reason for their particular "brain fog." My lack of sex may fog my brain to the point that I spend money on a Corvette convertible, damning me to a protracted battle with monthly car payments approaching four figures, as well as to the ridicule of my peers, but is that the responsibility of the government to prevent? If so, I wish to hell they'd been on the case.

Much of our consumer-focused economy is based on the fact that businesses influence the consumer to purchase "stuff" he or she doesn't really "need" in an absolute sense, based on unconscious motivations that cloud the consumer's judgment. Madison Avenue was built on the bodies of bikini models draped across the hoods of sports cars. The implications for the future of our economic system, and, ultimately, our political system, extend beyond the relatively low-hanging fruit of payday lending or overdraft fees.

So, let's keep the "debate" going, even if for the folks in agencies like the CFPB, the "debate" is likely over. They're busy grinding out empirical research that will demonstrate that payday lending is just the tip of the iceberg. There will be all kinds of "brain fog" from which the "unfogged" must save those without the cerebral wattage to power through the problem to the "correct" solution.

The Hype About Rising Interest Rates

The Guardian's Hiedi Moore recently wrote a very insightful piece that cuts through the conventional wisdom that's often picked up by an uninformed main stream media like a knife through hot butter. Her insight is into the actual cause of the dropoff in home mortgage refinancing.

Rising interest rates are not wrecking the housing recovery; what's wrecking the recovery is that house prices are rising faster than the ability of people to afford them. Maybe we thought we could cheat history, and that a housing recovery would bring about an economic recovery. That can't happen. The housing recovery can't start until the economic recovery begins.

Unfortunately, the economic recovery is overblown; in fact, the economy is stagnant, and there's no evidence of any progress despite years of stimulus by the Federal Reserve.

Similarly, the housing recovery was an illusion: the best housing stock has gone to large private investors, not individual homeowners.

Heidi points out that even rising interest rates remain at historic lows. The problem is not that rates are too high, it's that potential homebuyers can't afford the homes that are available for sale. Why? Because they aren't making enough money.

Personal incomes have collapsed since the recession, meaning households – many still struggling with heavy debt – can't afford the sudden rise in house prices and are not applying for mortgages any more. Anyone who manages to buy a house for the first time right now is not feeling rich: the National Association of Realtors found recently that 42% of first-time buyers have to make sacrifices to afford a new home.

This echos what Housing Wire's publisher Paul  Jackson has been saying for years: the housing market won't be fixed by government-sponsored loan modifications, but by jobs. Real jobs. Jobs that pay people a sufficient income to afford house payments. Like 1992, It's The Economy, Stupid.

Heidi makes two other points that bear watching. One is that banks may be lowering lending standards to chase declining demand. If that's the case, I haven't personally experienced it. I'm currently applying for a home loan and the increased underwriting requirements for paperwork and verification of every nit-picking detail is enough to drive you to drink, if you weren't already inclined, which, thank god, I am. If lenders are loosing their standards, you could not prove it by me.

Heidi also sticks a pin in the notion that we are in the midst of a housing price bubble.

There's no bubble right now because many people can't get the homes they want. Paradoxically, that will create less of a bubble even though housing prices are growing at bubble rates.

All-in-all, I agree with her conclusion that until more people have jobs and money to spend on housing, none should believe "the hype about interest rates."

North Las Vegas Bails Out On A Bad Idea

Although Richmond, California, is apparently undeterred by litigation, North Las Vegas, after having been sued by a resident over its plans to use the power of eminent domain to seize underwater mortgage loans from lenders, has decided to cease and desist from from further pursuit of the hare-brained scheme.

The city council in North Las Vegas, Nevada, on Wednesday rejected a plan to use eminent domain if necessary to help refinance "underwater" mortgages, an idea the mortgage industry opposes at a time when property markets are recovering.

The council voted 5-0 against the plan proposed by Mortgage Resolution Partners (MRP) for a partnership with North Las Vegas to buy the mortgages or seize them through eminent domain, a move critics said would unsettle the market for private-label mortgage-backed securities and push mortgage interest rates up.

The linked article also notes that other governmental entities like San Bernardino county and the cities of Fontana and Ontario have also bailed out of the scheme. While opposition from residents, mortgage investors, and such entities as Fannie Mae and Freddie Mac certainly played a part in the decision to drop such plans, a North Las Vegas city council member hit  a nail on the head as to why this plan may be headed to the dustbin of history: rising property values.

City Councilman Wade Wagner questioned the San Francisco investor group's proposed use of eminent domain for acquiring delinquent and performing underwater loans. A mortgage is under water when its unpaid balance is more than the market value of its property, a common problem in Nevada's third-largest city. 

"They want the performing mortgages they assume will default two, three, four years down the road. That's a mighty big assumption with property values climbing," Wagner told Reuters.

The article states that home prices in North Las Vegas are up 23% from the same period last year. If a rising tide lifts all boats, then a lot of underwater mortgages may be rising to to the surface. If the trend continues, taking a controversial, and perhaps expensive, action seems to make little sense.

The time for this scheme was, in my opinion, never. However, whatever your opinion on the merits of Recommended links and poststhe plan, time does not appear to be on its side. I guess the political hacks who dreamed it up to profit their "advisory" firm will have to come up with the next great idea to misuse police powers in order to line their pockets.

NY Fed Official: Let's "Facilitate" The Seizure Of Underwater Loans

As we discussed in April, the scheme to have municipalities seize mortgages from lenders through the use of the power of eminent domain refuses to die. It continues to stalk the nightmares of loan owners and servicers alike.

According to Housing Wire, North Las Vegas, Nevada, and Richmond, California are the latest desperate localities to consider buying into years of litigation that will inevitably follow the first attempt to exercise such a power. Industry groups are warning those cities that they are walking on thin ice.

In response to such actions, industry groups sent joint letters to these municipalities voicing their concerns, according to a recent note by the law firm Dechert.

[...]

In response to the growing acceptance of this practices, groups such as American Securitization Forum, American Bankers Association and National Association of Real Estate Brokers have gone on the offensive, appealing to lawmakers and policymakers to explain why such practices may be illegal and detrimental to the local housing markets.

For example, the joint industry letters argue that in both California and Nevada, the eminent domain power of local municipalities "only permits them to take the property of private owners who are domiciled within that municipality, and certainly not from owners who are not even within that state."

Furthermore, most residential mortgages are primarily held in securitization trusts, which are likely not California entities. Additionally, the beneficiaries of these securitizations are nation and international investors who are based all over the country and the world.

The letters also reiterated the destructive power the use of eminent domain would have on housing in those local markets and on the overall economic recovery.

"The letters caution that this will inevitably lead to complicated and costly legal battles over whether these municipalities had the right to seize the mortgages in the first place, which will only hinder the ability of individual homeowners and local housing markets to recover," the law firm explained.

While some municipalities that have considered the idea have decided that it's a bad idea, others will continue to take it seriously as long as people like the NY Fed's Robert Hockett think that the use of eminent domain is a dandy way of getting around the unfortunate necessity of having to get an agreement to write down the balances of loans from all those dastardly investors who own the loans.

"Specifically, such loans are subject to pooling and servicing agreements that require collective action by a large majority of security holders before a loan can be modified," said Robert Hockett of the Federal Reserve Bank of New York.

He added, "As a result, carrying out write-downs is challenging and sometimes impossible."

How do we turn a program that is seemingly impossible into the possible?

Hockett argues that one possible way to sidestep this problem is by having governments buy and restructure under water mortgages.

"By utilizing their eminent domain authority, state and municipal governments could bypass the coordination problems posed by the pooling and servicing agreements," Hockett explained.

He added, "They could then reduce the principal on underwater loans, lowering the amount owed by borrowers and thereby reducing the risk of default."

He added that in getting this process off the ground and into the stratosphere, "federal agencies could be helpful facilitators for all."

"Facilitator." We used to call it an "aider and abettor," but, then, we live in Orwellian times. By "all," I assume he means the municipalities and the borrowers. The owners of the loans would be getting something less than the remaining balance of their loans, which is perfectly fine in a land where private contracts are negated whenever the government decides that a small subset of people need some help in getting more than they bargained for. Since in many instances, the residential real estate markets, even the lousiest of them, are bound to recover before the end of the loan terms, who benefits from the rise in the value of the collateral when the property is eventually sold? The borrowers? The municipalities? Certainly, it isn't going to be the lenders.

That pesky right to own private property, and the resulting need to require the consent of the owner to give it up. It simply stands in the way of doing good as those in political power in a small slice of the country see the good. Therefore, it must yield.

A Bad Idea That Refuses To Die

Even though municipalities like San Bernardino have come to their senses and dropped a make-your-investment-banker-rich-quick scheme to seize underwater mortgages from mortgage lenders and wrote down the principal balances, the scheme refuses to completely die. I guess we'll have to use holy water, garlic, mirrors, fire, crucifixes and wooden stakes to stamp it out. In the interim, SIFMA continues to publicly pummel it.

In a recent post on its Pennsylvania + Wall blog, SIFMA's Timothy Cameron reiterates why those municipalities still considering this likely unconstitutional scheme to abandon it.

The proposals being touted target a very narrow slice of homeowners – those that are in private-label MBS and who are current on their existing mortgages, have good credit, and ideally don’t have existing home equity loans or other liens on the property. Those who are behind on their mortgage payments or have poor credit (which is the vast majority of homeowners needing help) will get no relief.

Within the small pool of qualifying homeowners, the proposal, on its face, will substantially undervalue their homes. In one example, the mortgage that investors would get paid $160,000 for is refinanced shortly thereafter for $190,000, with much of the additional $30,000 going to the plan’s backers after costs and a kickback to the municipality are accounted for. This is not fair compensation, since the amount paid is well below the face value of the taken note, and significant profits accrue to private parties.

In addition to the legal issues, the use of eminent domain will also be immensely destructive to U.S. mortgage markets in general and to specific communities using eminent domain, in particular. If the sanctity of the contractual relationship between a borrower and a creditor is undermined by the use of eminent domain, both lenders and investors will be reluctant to provide funding in the future. The result will be a significant contraction of credit availability, particularly in communities that have exercised eminent domain to seize loans. It will be much harder to get a loan: any loans that are granted will likely require much larger down payments, stronger credit scores and higher interest rates to compensate for this new and unprecedented risk. This contraction of credit availability would likely serve to halt any recovery in the municipality’s housing market, and could further depress housing values in the cities using eminent domain.

The last reason may be the most telling. Good luck with the future availability of affordable residential mortgage credit in your soon-to-be dustbowl of a community if you enact this scheme. The investment fund gets wealthy, of course, which is the impetus for this half-baked plan. All to help, but not so much, a narrow slice of the community.

Bad ideas never die. They never seem to fade away, either, unfortunately.