Eminent Domain Seizure of Underwater Mortgages: How it Works (And Why it Won’t)

This article was originally published on the Seattle Homes Blog:

Eminent domain seizure underwater mortgages

Eminent domain has become a popular topic in real estate circles recently as a number of local governments are contemplating using the power in a new way.  Cities like Hayward, CA and North Las Vegas, NV have recently considered measures that would attempt to seize underwater mortgages and lower their principal balances, under the guise of preventing foreclosures in their local markets.  Seattle is the latest city to begin studying the possibility.

Eminent domain has traditionally been used by governments to condemn and seize a property and, in most cases, is only allowable when the public good will be served by the taking.  Property owners must be compensated for the loss, meaning the seizing entity must pay fair market value to the property owner.

In the latest proposals, eminent domain would be used not to seize the physical property itself, but the mortgage attached to the property.  While a homeowner is the affected party in a traditional home seizure, in these cases banks, lenders, and investors are the mortgage owners and would be the concerned stakeholders.  “Mortgages” in many states are actually deeds of trust, but for simplicity’s sake we’ll call them all mortgages, and their owners investors.

Local governments are proposing to partner with corporations that specialize in the mortgage seizure process, and to use their investors to finance the purchase of those mortgages and their resale.  There are numerous legal and practical challenges facing this process, but here is how the process would likely play out if approved:

Step By Step – The Eminent Domain Mortgage Seizure Process

The city government condemns a mortgage on a home that is underwater.  In this case, the home is worth $200,000 (the city’s valuation), and the mortgage on the home has a $300,000 balance.

By law, when seizing property through eminent domain, the city must pay the investor back the fair market value of the property.  In this scenario, that property is the mortgage, not the home itself.  Proponents of this process have posited that the market value of a mortgage is 80% of the home’s current value.

In this case, the city would pay the investor who owned the mortgage $160,000.  To raise that $160,000, the city needs a financier.  They partner with a mortgage seizure specialist corporation.  This corporation has investors ready to make loans to the city and facilitate the process.

The corporation’s investor partners loan the city $160,000, which the city pays to the original investor.  The city now owns the mortgage.

The corporation’s investors now “refinance” the city’s mortgage at $190,000.  This new mortgage can be retained by the corporation’s investors, or packaged and sold with other loans as securities.

The city now has enough money to pay back the original $160,000 loan, plus a $30,000 margin for paying transaction expenses and profits to all of the necessary parties.  The corporation is paid a flat fee, the new investors get equity profit plus interest, and the city takes a cut as well.

Of course, the homeowner must technically agree to this new mortgage on his/her home.  When approached with the proposition of a $110,000 reduction in mortgage balance and a new position of $10,000 equity in the home, the home owner naturally agrees.

Who Determines Market Value?

While the process sounds like an innovative idea, there are a plethora of problematic issues.  The first is obvious.  Everyone profits, except for the original investor, who is paid only about half of the amount of his original mortgage balance.

The problems start when determining the value of the home itself, since the mortgage’s valuation is based on the home’s current value.  The city, which stands to profit from this process, is determining the value of the home.

While the condemning city is clearly not an independent analyst for the valuation, it is also likely not an able analyst.  City officials are far less skilled at property valuation than independent, full-time real estate professionals.  An unrelated appraiser would be the logical person to make this valuation but, in this case, the city is naming its own price.

A Mortgage’s Value is Much More Than the Home it is Tied To

Our next leap in logic is the belief that a mortgage is only as valuable as the home to which it is secured.  To demonstrate the folly of this idea, one of the mortgage seizure corporations, in partnership with Hayward’s city government, recently sent out letters soliciting the sale of underwater mortgages from the mortgage owners of over 600 local homes.  Not surprisingly, all offers were rejected by the original investors.  85 percent of those mortgages had on-time, current payments coming in, even though they were technically under water.  The investors were still seeing a healthy return on their mortgage investment, even when the home’s value had sunk significantly below the mortgage balance.

The value of a mortgage is not just in the value of the home or the principal balance, but in the likelihood of long-term interest payments being received.  Lenders lend money to earn interest.  Without a proper analysis of the present value of a mortgage based on its long-term repayment, a valuation process has little credibility.

Setting aside the lack of attention to interest payments, the valuation of a mortgage at 80 percent of a home’s value should cause plenty of raised eyebrows as well.  It is widely know that mortgages are being made up to 97 or even 100 percent of a home’s value.  These are mortgages backed by investors who understand their worth, and can easily demonstrate a mortgage’s market value far above 80 percent loan-to-value.

Hands In The Mortgage Cookie Jar

This process hits its lowest credibility point when the straight-faced participants refinance a mortgage on the same property at a higher loan balance.  The very same set of characters tell the original investor “Your mortgage is worth X,” while telling their own investors “This mortgage is worth X + Y.”

If it weren’t so obvious and financially irresponsible, it would be comical.  The entities in this process will be required to prove in a court of law that they’ve paid fair market value to one group of investors, and repeatedly, successively, resold those same assets to other investors at higher prices in a short time period.

Unfortunately for proponents of the eminent domain process for seizing mortgages, this is where the rubber meets the road.  Without that profit margin, there is no mortgage seizure corporation running the program.  There are no investors on the back end lending money to the city.  There is no one to refinance the mortgage later.  No one is willing to make this process go forward without shorting the original investor, because when you pay fair market value, there are no ill-gotten profits to spread around.

If The City Gets What It Asks For

There may still be some cities that push forward with this process, even with all of its legal problems.  As Seattle has gotten a recent taste for the seizure madness, the less-than-convincing mantra has been “Let’s just test the courts.”  While neither Seattle nor any of the other cities have officially started using eminent domain in this way, there are many proponents pushing the cause heavily.

A lack of foresight on these issues would likely cause a municipality far more headaches than the relief it might find through a few foreclosure rescues, however.  There will be lawsuits from investors and banks, some of which have already been filed and are waiting for an official opponent.

The nation’s largest lending institutions are weighing in with serious concerns.  HUD, which supplies FHA insurance, has said that it will likely not insure any new loans that are created through eminent domain seizure.  FHFA has said that it may limit or stop Fannie Mae and Freddie Mac from lending altogether in cities which approve this process.  Those two statements alone should send chills down the spine of a city leader concerned with the valuation of local homes.  Add in private investor reluctance to take on a risky market and a city would see vast repercussions, from sinking sales to diminished home values due to the lack of access to financing for its local residents.

The Gift That Gives Back

To add personal damage to the community issues, real estate professionals familiar with short sales will quickly see the similarities in tax concerns.  The IRS often looks on debt forgiveness as income or a gift, for federal tax purposes.  The result of the mortgage reduction could, without further legislation, create a taxable six-figure income gain for the homeowner, for which they might owe tens of thousands of dollar in the following year.

Practicality and the Current Reality

Maybe the most interesting concern is whether or not the process would even have an effect on underwater homeowners in the end.  The likelihood is that every single transaction would include legal challenges from at least one opponent.  Not only would the individual investor/mortgage owner contest the seizure, but larger groups of bond holders would as well.  Many mortgages are bundled in large groups as securities, and the removal of any of those individual mortgages from the bundle would damage the value.  Many individual bondholders would be financially affected by a single transaction, making the seizure of this class of mortgage either an invitation to a multiparty suit, or totally off limits to the city.

In some markets, the determination of market value can be subject to a jury trial.  This would be a city’s worst nightmare, eating up massive amounts of time and local court budgets for every single seizure.  Every loss in court would be a net negative to the city’s budget and one more homeowner who couldn’t be helped because the profit margin on the transaction naturally disappeared under scrutiny.

In the bigger picture, real estate value appreciation is being seen nationwide.  We’ve erased years of losses, and the number of underwater homeowners shrinks by the month.  Foreclosure numbers are dropping as homeowner confidence grows and more people decide to keep paying their mortgage until they reach an equity position once again.  By the time any of these seizure processes begin to get legs under them, they may be focused only on a tiny percentage of homes that are still underwater.

Eminent Domain and the Necessity of Clear Public Utility

In the end, the groups proposing to seize mortgages may be missing the most basic element needed for the use of eminent domain powers.  There must be a “public good” that is created through the use of eminent domain.  Good ideas, vision, and purpose do not suffice.

For this process to provide a legally-necessary positive public outcome, the proponents would need to show that:

1) they would be able to reduce a significant number of homeowners’ mortgage balances,

2) those reductions would prevent a significant number of homeowners from being foreclosed upon who would have otherwise lost their homes if the city had not intervened,

3) the city’s greater housing situation would be perceptibly improved by those specific homeowners’ improved plight,

4) the collateral damage to the local real estate market from restricted access to lending for the city’s home buyers and sellers would not negate the potential positive impacts of the mortgage seizure process.

This is not an easy thing to demonstrate, and it should not be.  The use of one of our government’s most onerous powers over individual private property rights should, and does, have a very high bar to clear before it can be exercised.  With the current proposal for the use of eminent domain to seize underwater mortgages, we’re still a far cry from clearing that hurdle.