A decade ago, eminent domain was a pair of dirty words. In many ways, it still is. But as the foreclosure crisis rolls on -- leaving in its wake abandoned homes, blighted neighborhoods and homeowners with underwater mortgages -- eminent domain is receiving a kind of makeover. California's San Bernardino County may take an unusual step to resolve its foreclosure crisis and use eminent domain to seize underwater mortgages and restructure them on behalf of homeowners.
It's based on an approach developed by Robert C. Hockett, a Cornell University law professor, and endorsed by Yale housing economist Robert Shiller. Most of the coverage about Hockett's plan has been on the business pages, where the investment community has flat-out opposed the idea. But how would it help or hurt a local government that chose to use eminent domain in this way? I caught up with Hockett and put that question to him. I also asked him to lay out how the approach would work. Here are edited excerpts from our conversation.
Why would a locality want to use eminent domain on mortgages?
It's a way to fight off urban blight. When mortgage loans are held or owned by individual banks, the banks can write down bad loans. But with securitized mortgage loans, the loans can't be written down in the same way. Bondholders number in the millions and are scattered all over the world; they can't come together to agree on the sale of at-risk loans. The pooling agreements and service agreements prevent or impede the selling off of underwater loans and the writing down of principle. So, we have a massive set of collective action problems.
Currently, those mortgage security bonds are non-marketable assets. Investors can't sell those things, and that's a problem for them. When homeowners are underwater, they are at serious risk of default. It's very much in the interests of those bondholders to either modify those loans or sell them off to someone who can modify them. The problem is all these impediments. Eminent domain sidesteps those impediments and enables what needs to be done in the interest of the homeowner, the community and the bondholders themselves. It's a win-win-win solution -- if done right and not squabbled over by special interests.
How is a local government a winner?
It can keep residents in their homes and keep them from defaulting. The loans in the program are targeted: They are loans that are current and that the homeowner is paying -- but paying and staying current against the odds. Enough statistics are available to determine with confidence what the probability of delinquency is on a particular loan -- even if that borrower is current. The idea is to prevent that default before it happens by writing down the principle until the home is no longer underwater.
It also prevents sudden hits to property prices. These can go way down when there are lots of foreclosures. That's bad for all residents and bad for a city.
What's the step-by-step process? How would it work?
Through eminent domain, the locality seizes the mortgages and pays fair market value for those loans. The city doesn't use tax revenue to buy them. The money comes from investors who are going to be the new loan holders. The city refinances those loans and writes down principle. Borrowers no longer owe more on their house than the house is worth. The new loans are now manageable. Once that is done, repayments on those loans are paid to investors who bought the loans in the first place. Using eminent domain is a way of getting at contract rigidities that prevent bondholders from acting in their own interest.
What's the basis in law for using eminent domain to seize mortgages?
It's a common tool governments use when it's necessary to act on behalf of the entire community. Though we think of eminent domain law as applying to land and buildings, it's not unusual for it to be used to take intangible property. It's just not as widely known. When land is taken, it's a high profile event -- people notice it. By contrast, when intangible property is taken, it doesn't get a lot of attention. Governments take stock in the interest of consolidating ownership of a corporation when that's necessary for a government purpose. Intellectual property can be taken. Any taking has to be for a valid public purpose and fair market value must be paid.
What if mortgage security bondholders object to the price offered?
It's always possible to have court proceedings on fair market value -- if there are disagreements over what the value is. The whole process is overseen by the courts to make sure everything is done with due process and within the law. But an investor in a mortgage-backed security is not the direct owner of the loans. The legal owner is a trust. The investor owns bonds issued by the trust, which owns the loans. That means bondholders don't contest the value. The trustee who administers the trust and who has fiduciary duties to the bondholders is the person who decides whether or not to contest the fair value.
What risks are there to a locality that chooses to do this?
It's hard to see any significant risks. No taxpayer money is being used. You might alienate constituents with eminent domain. But it's hard to imagine residents not in favor of preventing foreclosures and urban blight. The only "risk" a city might face is if there's a protracted contest in court over fair valuation of the underlying mortgages. That takes time and attention, and there are costs in litigation.
The investment community has been raising objections to the approach.
A lot of these securities are zombie assets. The book values of the assets are completely out of sync with real values. Because accounting rules are what they are, it's possible to present yourself as having higher value assets than you really have -- you can mark them at book value, but book value is out of sync with actual value. Those objecting can put off the day of reckoning and pretend the securities are worth more than they are. Eminent domain recognizes up front there's a loss. It doesn't cause the loss, it just recognizes it.
It speaks well of the plan that investors are willing to put up money. That's a strong signal that there is wasted value that can be recovered. If that value is divided among stakeholders, everyone can win -- homeowners stay in their homes and are no longer underwater; the city prevents blight and foreclosures; bondholders gain because they are now able to sell an unmarketable asset.
Full disclosure: Hockett has no financial interest in Mortgage Resolution Partners, the company that proposed the idea to San Bernardino County. He has, however, done consulting work for the company.