Pitchmen offering eminent domain as a no-cost solution to cities dealing with high levels of foreclosures continue to creep around the country. Their proposed plan to abrogate a perfectly valid contract by seizing mortgages to force loan restructurings is an offer that should be refused. Unless, of course, the cities deliberately want to further depress housing prices in their communities at a time when housing prices are seen to be recovering across the country.

Earlier this year, San Bernardino County (CA), which had been ground zero for the debate on this issue, sensibly took the use of eminent domain off the table as they considered efforts to address the county’s housing problems. More recently, the City of Brockton (MA) has also decided not to pursue this proposal citing the legal questions surrounding the use of eminent domain in such an unprecedented fashion.

Still, municipalities around the country (most notably in, North Las Vegas and several northern California cities) are in the midst of considering the use of eminent domain to help struggling homeowners. We’re working with these cities to make clear the full market impact and the legal risks in pursuing this proposal.

Here is a good refresher on how this works:

The plan, promoted by the pitchmen and the lobbyists of the investment fund Mortgage Resolution Partners, would have local governments seize control of mortgages where the loan amount exceeds the value of the home that secures it. The eminent domain powers of the municipality would be used to take loans from the private investors—and here we are talking about many Main Street investors who have provided capital via investments from their retirement funds or hard-earned savings— in mortgage-backed securities (MBS) that own them, and refinance them through government-guaranteed mortgage programs.

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.

Timothy Cameron
Managing Director, SIFMA Asset Management Group (AMG)