Foreclosure and the Eminent Domain Solution Explained
Richmond, Calif.’s plan -- which dozens of localities are considering -- is facing legal and legislative challenges. What are the pros and cons of seizing underwater mortgages using eminent domain?
A year ago, I interviewed Robert Hockett, a law professor at Cornell University, who's one of the brains behind a radical approach to solving the foreclosure crisis. Hockett advocates using eminent domain to seize underwater mortgages that lie embedded in securitized mortgage bonds and restructuring them on behalf of homeowners so that payments are affordable. At the time of the interview, several municipalities in California's San Bernardino County were exploring the idea, while Wall Street -- specifically the Securities Industry and Financial Markets Association (SIFMA), which represents bond dealers -- was vehemently opposed to it.
Fast forward to today, and several things have changed: Cities in San Bernardino County ultimately passed on Hockett's plan, but Richmond, Calif., is moving forward with it. A dozen other localities are giving it serious consideration, including El Monte, Calif.; North Las Vegas; and Irvington, N.J.
The strategy, however, is still controversial. In the past few weeks, banks representing major bond investors sued Richmond; Fannie Mae and Freddie Mac, which are among the biggest buyers of private home loan bonds, signed on to the suit. The Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, threatened to pull Fannie and Freddie out of cities employing eminent domain relief on mortgages. And U.S. Congressman John Campbell of California introduced legislation to quash the efforts of cities like Richmond.
With the rhetoric rising, it's time to review the basics of the concept and spell out the pros and cons.
How does it work?
When mortgage loans are held or owned by individual banks, the banks can write down bad loans. But with securitized mortgage loans, that can't happen in the same way. To get around that hurdle, localities can start by asking the owners of the loans to sell them at prices based on financial models or comparable trades sanctioned by courts.
If the owners refuse to sell, under Hockett's strategy the locality could then move to seize the mortgages and pay fair market value for them. The purchase money would come from a pool of investors, and the city would refinance the loans and write down the principle. The new debt would be insured by the Federal Housing Administration. Homeowners would no longer owe more on their houses than the houses are worth. Repayments on the loans would be paid to the investors who bought them.
What's the argument for the approach?
Advocates for the plan -- including the mayor of Richmond -- say the goal is to help communities by fending off foreclosures that cause blight and create other costs. It's especially attractive to less affluent cities that have been hit hard by the housing crisis. Richmond, for instance, is a largely blue collar city (population 106,000), where almost half of the homes are underwater. In a recent interview, Richmond Mayor Gayle McLaughlin said the city had 900 foreclosures last year and there are "just as many in the pipeline this year. It has devastated our neighborhoods."
What's the basis in law for using eminent domain to seize mortgages?
Hockett, Mortgage Resolution Partners, a San Francisco-based private investment firm that is a key player in raising investment money for the plan, and McLaughlin say governments use eminent domain to take property when it's necessary to act on behalf of the entire community. Most people think of eminent domain as applying to land and buildings, but it's not unusual for it to be used to take intangible property. Eminent domain, though, has to be for a valid public purpose and fair market value must be paid.
What are the objections?
The financial industry sees the seizing of mortgages under eminent domain as a violation of the Contract Clause in the Constitution and an impermissible "taking" of private property under state constitutions as well. On its website, SIFMA states that the plan "would be immensely destructive to U.S. mortgage markets by undermining existing securitization transactions, which would significantly reduce access to credit for mortgage borrowers in affected areas."
SIFMA CEO and former U.S. Sen. Judd Gregg has said that the seizure plan would "harm the savings of everyday Americans around the country and have a negative impact on already stressed pension funds and the value of their investments." That is, the program would hurt owners of mortgage bonds by paying them too little for loans.
Tim Cameron, managing director of SIFMA's Asset Management Group appeared on Fox News where, among other points, he argued that a housing recovery is underway and fewer homeowners are underwater. Therefore, he said, the strategy is not only illegal, but unnecessary. Cameron also charged that the seizure strategy is a "plan by certain investment companies to earn a profit." According to Zillow, a real estate information service, 25.4 percent of U.S. homes with a mortgage were underwater in the first quarter of 2013, an improvement from 31.4 percent in the first quarter of 2012.
What are proponents saying?
They agree that the housing market is improving. Still, they say, cities considering using eminent domain are worse off than the country as a whole. In addition, investors will not be made worse off by the sale of any loan. Hockett says that a lot of these securities are "zombie assets with book values that are out of sync with real values." Eminent domain doesn't cause the loss in value of the bonds: it just recognizes it, he says.
What will happen?
In Richmond, city officials have sent notice to the holders of more than 620 underwater home mortgages in the city, asking them to sell the loans to the city for 80 percent of the fair value of the homes. The loan owners have been given a mid-August deadline to accept the deal. Should the owners of the loans refuse, the city says it is prepared to seize the loans using eminent domain.
There's been no action on Rep. Campbell's bill. The courts have yet to rule on the lawsuits. The FHA, which the plan counts on to insure the restructured loans, announced it was not sure the new mortgages would qualify for FHA insurance. And other cities interested in a similar seizure strategy are taking a "wait and see' attitude, making Richmond the test case.