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September 4, 2012

Cities explore use of eminent domain to seize underwater mortgages and prevent foreclosure

by Central Coast Lending
Neighborhood (1)

The San Francisco based company Mortgage Resolution Partners (MRP) has proposed an eminent domain solution to the underwater mortgage problem and several local governments are listening.

California cities Ontario and Fontana (joint with San Bernardino County), Sacramento, Elk Grove and Suffolk County (New York) are exploring the Homeownership Protection Plan, which would use private funds to acquire underwater mortgages and then restructure the loan with less principle and a more affordable interest rate. According to MRP, the action would alleviate pressure on distressed homeowners and prop up blighted local real estate markets.

To enact eminent domain, the government would need to establish the positive benefit for the people. Then, the court would would take arguments to define “just compensation.” Another question about the use of eminent domain involves the “tangibility” of a mortgage as property, which can be taken for the public good.


Why help underwater homeowners?

“Underwater” refers to mortgage holders who owe more than their home is worth on the market. Client Bob might have signed a $400,000 mortgage at a 5.50 percent percent interest, only to have housing prices slump and bring the value of the home to $300,000.

Nearly 31 percent of homeowners are underwater, which represents about $1.15 trillion dollars in negative equity. These mortgage holders are statistically the most likely to default. In somewhat of a catch-22, to avoid adding potentially high-risk loans to their portfolios, lenders often reject refinance applications from underwater borrowers, which keeps the at-risk homeowners locked at high interest rates.

The consumer problem

Consumers are locked into challenging loan terms and stretched thin. During this time of job layoffs and depressed consumer spending, a lower interest rate with reduced monthly payments would free income for spending elsewhere. It is estimated that consumer spending accounts for up to 70 percent of the national economy.

The real estate market

Real Estate is a neighborhood problem. Home prices are derived from certain tangibles (size, quality, etc) and intangibles (comparable sales). When the sales prices of housing in a particular area fall, the cost of real estate in the area is devalued.

When banks foreclose on a property, they discount the ensuing sales price to move through the excess supply quicker. As cheap properties enter the market, they drive down home prices in the area.

Home values are not absolute, they run on a spectrum relative to the supply and demand of the local market. This is why prices shut up during the bubble (high demand) and why they slumped back during the recession (low demand, high supply, low home price sales).

Blight and cities

As folks lose their homes and leave the area, housing developments stand empty, stores lose customers and communities sink into disrepair. With a smaller tax base, the local government might cut the budget (or file for bankruptcy) and cannot help. The downward spiral is documented and inevitable.

Billed as a local solution, the Homeownership Protection Plan would attempt to keep mortgage holders in their homes and pave the way to economic recovery for struggling cities.


How would the plan work?

Backed by private investors, the aforementioned Mortgage Resolution Partners would advance the local government the sum needed to buy underwater mortgages at the current, reduced market value. The program would profile “responsible underwater” homeowners who are current on payments.

The government would then slash what borrowers owe and refinance the loan back to them at more favorable terms.

MRP would make a flat $4,500 from each transaction.

In Sacramento, half of the mortgage holders are underwater, but it is estimated that just 1 in 10 mortgages would qualify for the program. Still, local leaders have expressed desperation to make a difference after perceived ineffectiveness by the state and national government to combat the housing crisis.

Freddie Mac and Fannie Mae held mortgages, which accounts for about half of all home loans nationwide, are not included in this plan. The Home Affordable Refinance Program (HARP) and other iterations strive to help Fannie and Freddie borrowers, but there is very few options out there for mortgage holders from private lenders.


Ok, so what is the downside?

Lenders, investors and industry groups have come down hard against this idea. The most prevalent protests that we have seen are as follows:

  • Credit crunch: would lenders be less inclined to lend money when the mortgage could be seized by eminent domain?
  • Moral hazard: would this bailout action encourage reckless borrowing?
  • Mortgage securitization: would the mortgage securitization market take a hit?
  • Tightened standards: might lenders underwrite even more defensively for the sake of protection?


What now?

Much of the broad national housing market is on the rebound, but there are still many struggling regions. These areas will do their due diligence to understand the plan and take feedback. The obstacles for implementation are many – stiff opposition from business leaders and the various legal hurdles and at the rate government moves, any implementation is not very close.

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