Underwater Mortgage Plan: Will it Sink or Swim?

by: Anthony F. Della Pelle
20 Aug 2013

It has been several months since we last reported on the scheme to use eminent domain to seize “underwater” mortgages in various places around the country.  It appeared that the idea died out earlier this year, but it has recently come back with a vengeance.  In recent weeks, several California cities have advanced efforts to implement this plan, including the northern California City of Richmond, which has notified the owners of about 620 loans that the City would use eminent domain to take the loans if they refused to sell at a steep discount.  This has already prompted a federal lawsuit by investor groups, including Black Rock, PIMCO and others to obtain an injunction stopping the scheme before it even gets started.  This suit may only represent the tip of the iceberg in this underwater mortgage plan.

The plan, originally proposed by San Francisco-based Mortgage Resolution Partners (“MRP”)(ironically a private investment firm itself), calls for borrowing the government’s awesome power of eminent domain to seize mortgages which exceed the value of the  homes upon which the loans are secured.  The idea is to take the mortgage debt, not the home, and refinance the debt at the customary 80% of the current value of the real estate.  The entire process assumes that the mortgages can be taken at a steep discount merely because the value of the collateral — the homes – has fallen.  Oh, and by the way, the package (substituting the old, underwater debt, with new, improved debt) would be entirely arranged by MRP (for a fee of several thousands of dollars per loan) and handed over to the distressed cities on a silver platter.

Sounds easy, right?

Unfortunately, this plan is wrought with several significant flaws that suggest it is more likely to drown than survive.  First, any use of eminent domain requires that it serve a public purpose.  Whether taking a group of private mortgages from one group of investors and giving them to another serves any public purpose remains to be seen.  Plan supporters who suggest that this will be a panacea for the housing crisis in their areas may be surprised  when they realize that the credit and housing markets may actually suffer if the plan is implemented.  Traditional takings involve real estate acquisitions.  This plan proposed the taking of pooled mortgage debt – pieces of paper which are backed by investors in bonds in other similar instruments.    Without support from federal loan regulators  like the Federal Housing Finance Agency, which has consistently opposed the plan, about 90% of mortgages may be unavailable to borrowers in areas where eminent domain is used.  This could effectively strangle a homeowner’s ability to finance real estate purchases in those areas.  Public purpose served?  Strike one against the plan’s supporters.

The next major obstacle is also rooted in the U.S. Constitution, which in its Contracts Clause bars the government from enacting any law which impairs private parties’ obligations under contracts.  This is the precise purpose of the MRP plan — to void the “bad” underwater mortgage contracts and replace them with new ones.  One private party is out, and another is in.   To make matters worse, the Constitution also has a Commerce Clause which provides that state and local governments cannot unduly interfere with interstate commerce.  Here, the mortgages cover real estate in one state, but the owners of the “property” taken will be in scattered states, and implementing the plan in say California or Nevada may be discriminatory to persons in either those states or perhaps homeowners in other states who want to be saved before they sink, but have the bad fortune to have the exact same mortgage as their fellow citizens in the states where the plan is implemented, so they remain underwater.  This makes it seem like the count is now 0 and 2 against the plan’s supporters.

The last significant problem with this plan is that it is entirely premised upon taking the existing loans at a significant discount.  Say a mortgage is underwater because it has $300,000 of outstanding debt on a home now worth $200,000.  The plan supporters suggest paying the original investors $160,000 – about 80% of the current value of the home.  But why should the original investors agree to more than a 45% discount on their investment when it is still performing?  Last time I checked, the Constitution required that a property owner in a condemnation matter be paid just compensation —  the amount that would indemnify the owner for his or her loss.  If an owner loses a $300,000 asset that is performing (as most of the targeted loans are), why would he or she  take $160,000?  Will that scant amount indemnify him or her for the loss?  If not, the result is unconstitutional.  Add to the direct cost, the indirect cost of fighting off the litigation that has already spawned and is poised to multiply – even if the plan supporters pull a rabbit out of the hat and eventually win.  The only thing scarier than this strike three for the plan is the fiscal chaos it is all but certain to create if the “bargain” prices that have been hypothesized do not result.

Very few quick fixes end up working at all, and those that do, usually don’t last.  This one seems to have all the makings of another crisis, just about ready to erupt.  If that happens, the cities with underwater mortgage problems that hope for salvation may end up much worse off than they were to begin with.

For our prior blog posts on this topic:

Underwater Mortgage Plan Rejected by County That First Proposed It

Should Governments Use Eminent Domain To Acquire Underwater Mortgages?

Eminent Domain to Save Property Owners From Foreclosure?

Widespread Disagreement on Plan to Use Eminent Domain to Acquire Mortgages