Pethokoukis, Economics, U.S. Economy

Will local governments use eminent domain to restructure underwater mortgages — and kill the housing recovery?

Image Credit: Shutterstock

Image Credit: Shutterstock

Maybe this week’s US financial market volatility isn’t just about the Fed tapering its bond-buying program and China’s slowdown. Here’s why: the odds just increased that US municipalities will use eminent domain powers to seize underwater mortgages and then write down debt for homeowners.

In North Las Vegas, Nevada, the city council voted Wednesday to enter into a 60-day advisory services agreement with Mortgage Resolution Partners, a firm pushing the eminent domain idea. After consulting with MRP over the next two months on how the process might work, the city council will consider the proposal in August and perhaps vote to proceed with eminent domain refinancing.

This is pretty big news with potentially huge implications for the nation’s housing finance system. Analyst Jaret Seiberg of Guggenheim Washington Research Group:

North Las Vegas on Wednesday evening took a major step toward using eminent domain to refinance underwater borrowers. There is a growing risk that a community will proceed with eminent domain refinancings, which could hurt mortgage originators and holders of mortgages and RMBS not backed by the government. …

Our concern remains that eminent domain refinancings will spread as soon as one community shows that it is a viable policy. We believe the use of eminent domain to refinance underwater borrowers could damage the housing finance system by causing investors to question if the loans are really secured.

Eminent domain refinancings also could have more micro impacts in communities that use eminent domain refinancings by reducing their access to mortgage credit. That could impact lenders in those communities as well as home values.

1. This idea was previously floated, most notably, in San Bernadino County, California, another region with vast numbers of underwater and foreclosed homes. Back in January, local governments decided to abandon the controversial idea after huge push-back from mortgage and investment trade associations, particularly the powerful Securities Industry and Financial Markets Association.

Here is what Seiberg said last year about the San Bernadino plan and its impact on the nascent housing recovery:

– Not only would this plan result in massive prepayment risk for MBS holders, it also would impose losses on whoever holds the credit risk on the mortgages. We note that this clearly could be used against non-agency mortgages, though there may be broader legal issues in using it against agency mortgages.

– Our expectation is that the market would demand a much higher risk premium going forward if eminent domain catches on as one would now have to assume that there is massive prepayment risk whenever a loan is underwater. That means higher mortgage interest rates.

– We also believe down payment requirements would rise as lenders would want to ensure there is little risk that a loan results in negative equity and is thus subject to eminent domain.

– All of this would be another headwind for a housing market that is desperately trying to recover despite repeated government actions that we believe are impeding such a recovery.

2. If the city does go through with this plan, all eyes then turn to Washington. See, the North Las Vegas effort would probably apply only to 15% of the city’s 30,000 underwater borrowers, ones not backed by Fannie, Freddie, or the FHA. And the Federal Housing Finance Agency, which oversees Fannie and Freddie, made it clear last year that it opposed using eminent domain to write down mortgages.

3. But the FHFA might be getting a new boss. President Obama has nominated Representative Mel Watt, a North Carolina Democrat, to be the new director of the FHFA, replacing Ed DeMarco, the acting director. Given the North Las Vegas news, Republicans would seem likely to raise the issue in Watt’s confirmation hearings. Watt seems likely to be more amendable to the idea than DeMarco. Indeed, former Treasury Secretary Timothy Geithner criticized DeMarco for not allowing the government-sponsored enterprises to pursue principal reductions. Seiberg on Watt’s fate:

Whether Watt is confirmed is purely a political decision. We believe Republicans want to block him, as they do not want to put a Democratic politician in charge of running Fannie and Freddie. Yet the GOP also does not want to be seen as opposing a popular member of the Congressional Black Caucus. That is why the confirmation hearing my be decisive.

So the importance of the Watt nomination just increased substantially.

4 thoughts on “Will local governments use eminent domain to restructure underwater mortgages — and kill the housing recovery?

  1. I;m not a fan of the rationale behind this move my local governments, but the big lenders have no room to talk or try to throw their weight around: a) for years, they made, or greedily created and perpetuated a secondary mortgage marketplace to sell, mortgages with *NO* equity/down payment, and b) they have refused and hindered and delayed all efforts to fix or resolve the problems those lending practices created, on either a small or large scale. If you keep resisting long enough, other ‘players’ will find a work-around – just like banks do when/if the government imposes new lending restrictions.

  2. This clearly goes too far. However, there have been reasonable proposals that lenders that made loans based on highly speculative values should take a “haircut” on them which would actually be better than the potential losses on a foreclosure if they didn’t have insurance. And, it is the Fannie and Freddie loans that are probably the ones that should be targeted first, then those insured by them. A reasonable plan would be a maximum 20% write down with a refinance that was a true ARM tied to a US Treasury issue.

    While in the future, a higher down payment might eliminate the underwater problem, it is more to the point that lenders are the ones that can prevent speculative bubbles by refusing to make loans based on speculative values and in effect requiring a down payment that makes up the difference between the actual value and the speculative value.

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