On Thursday, the Federal Housing Finance Agency (FHFA) sent a strong message discouraging municipalities from using eminent domain to help bail out distressed homeowners — dramatically changing the tenor of a closely watched legal dispute over the maneuver currently taking place in California. The federal agency said it would direct Fannie Mae and Freddie Mac, which it oversees, to “limit, restrict or cease business activities” in any town using eminent domain to seize mortgages.
But let’s back up for a minute to explain. The housing market has been on fire of late — so much so that a couple of cities are seeing higher home values than before the bursting of the real estate bubble. Most of the country, however, is still in recovery mode. Despite more than a year’s worth of rising prices, more than 20% of all mortgagors remain underwater — meaning they owe more on their home loan than their house is worth.
And many of these hapless homeowners are concentrated in areas like Richmond, Calif., where half of all mortgagors remain underwater. In theory, it would make sense for lenders in such blighted areas to work with homeowners to reduce the amount they owe. That’s because severely underwater homeowners are much more likely to walk away from their mortgages and give up their home in foreclosure — a very expensive process for lenders. And when many of the foreclosures occur in one city, that creates a negative feedback loop that just makes the situation worse for lenders and citizens alike.
The problem is that in places like Richmond, the mortgage “lenders” in question aren’t banks, but a wide array of mortgage-backed-security investors. And the structure of these mortgage-backed securities makes it very difficult for stakeholders to get together and agree on what is in their collective interest.
To address this problem, a group of financiers called Mortgage Resolution Partners (MRP) has been pushing the idea that towns should use eminent domain to force investors to sell homes to the municipality at current market value (as opposed to the prebubble face value of the mortgage). The town would get the money for the purchase from MRP, and then offer to sell the home back to the homeowner for slightly more than it paid, leaving a small profit for MRP.
Mortgage Resolution Partners has been pushing this idea for more than a year now, but Richmond is the first city to actually move forward with it, announcing this week that it had sent letters to investors in more than 620 homes, declaring its intention to use eminent domain to purchase the homes at their market value.
Not every investor, however, is pleased about this approach. On Wednesday, a group of mortgage investors and servicers filed a lawsuit against Richmond, alleging that their plan was unconstitutional and illegal. This isn’t surprising. If every investor were on board with these write-downs, we would probably have seen voluntary write-downs already. Plus, according to the Wall Street Journal, more than two-thirds of the mortgages Richmond is looking to seize are current on their payments. These are unlikely to be the mortgages investors would choose to write down if given the choice, because these are the mortgages least likely to default.
Whether or not the courts would brook Richmond’s approach to this problem is difficult to say. Cornell University law professor Robert Hockett has long supported the use of eminent domain to help heal communities blighted by the foreclosure epidemic, and has argued that local governments possess well-established authority to do so. Indeed, several other California cities are in talks with MRP about launching similar initiatives. On the other hand, municipalities typically seize actual property in eminent domain cases, and it is unclear how the courts will react to the novel approach of seizing mortgages instead.
But after Thursday’s FHFA announcement, we might never find out. As it stands now, Fannie and Freddie own or guarantee 90% of all new mortgages issued in the U.S. If the FHFA were to direct these two housing giants to cut off mortgage credit from Richmond, or any other municipality, that would more or less put an end to home buyers’ ability to finance real estate purchases in those areas. As Guy Cecala, publisher of Inside Mortgage Finance, told the Los Angeles Times, “It is pretty much a death sentence these days in terms of mortgage financing.”