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Why Using Eminent Domain To "Fix" Underwater Mortgages Must Be Stopped

By Donna S. Robinson | July 11, 2012

Lately a number of local municipal governments in California have been considering a seizure of thousands of properties with underwater mortgages, by utilizing their "police power" known as "Eminent Domain". But eminent domain was never intended for this purpose.

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Eminent Domain is a long held concept in which it may, under certain circumstances, force a property owner to sell property that will be used for the good of the general public, whether the property owner wishes to sell or not. It is commonly used in cases of building major roads, rights-of-way, or building of facilities for general public use.

The governing authority that is taking the property for said public use also has to pay the owner the "fair market value" of the property being taken. But determining a "fair market value" in cases of eminent domain is often a point of disagreement between property owners and "the state". And the state usually prevails where there is a legitimate public use.

But in the California case, the idea is to perform hundreds or even thousands of eminent domain seizures in order to refinance the existing mortgages, which are currently underwater. There are investors who own those notes; Investors who stand to lose big. And more troubling, there is a private investment company that is pitching this concept to the local authorities, and promoting this idea as a solution that is in the best interest of the public, and therefore, acceptable practice under eminent domain.

But this is a private company that stands to make big profits at the expense of another group of private investors who legitimately hold the existing mortgage notes. Without these investors, there would be no private mortgage market.

Edward J. Pinto, a Senior Fellow of the American Enterprise Institute, and himself a former Fannie Mae executive, makes some very important points about what all of this means to the people and companies who represent the very foundation of the housing industry. The people who actually invest in those mortgages, and in so doing, make the private mortgage industry possible in the United States.

Here is his analysis of the basic scheme for refinancing the mortgages that would be seized:

Assume a paying loan with a $300,000 loan balance and a $200,000 current home value. Investors would be paid 85% of the current home value or $170,000 – a discount to face value of $130,000 or 45%.

At an assumed default rate of 50% and an assumed loss upon default rate of 50% across all loans, the average performing loan has a value to investors of $225,000, not the $170,000 proposed to be paid under the plan. To reach the price the plan envisions, over 85% of the loans would have to default.

You may be surprised to know that you could be affected. What if YOUR pension fund owns some of these mortgages. Especially if you are a public worker in California.

These bond holders aren't some gang of foreign thieves. Many of the investors at this level are companies that invest monies for teacher, police and firefighter pension plans. The real secret of the mortgage problem in the U.S. is the degree to which average Americans could be impacted by actions like this, especially if this became a widespread practice.

But as Mr. Pinto also points out, the controversial nature of this approach and the amounts of money involved would give both sides ample motivation to fight in court, possibly for years, which would render the plan basically useless.

And allowing any private firm to use the process as a profit center would be a very dangerous precedent that would fundamentally alter the purpose of eminent domain and open up property owners to all kinds of potential reasons for seizure. It would also endanger the viability of the secondary mortgage market as an investment vehicle, and force taxpayers to guarantee virtually 100% of new mortgages.

To local government officials searching for a solution to a long, tough housing crisis, this may sound like a great idea. But these same officials are not experienced real estate professionals and do not usually understand how the mortgage finance industry functions.

To put it in terms that Californians can understand...Allowing eminent domain for the seizure of underwater mortgages is the financial equivalent of a major oil spill in San Francisco Bay. It's going to pollute the entire housing industry and poison the very creatures that make the "mortgage eco-system" work.
Donna S. Robinson is a real estate industry veteran. She also speaks and teaches on real estate investing. Follow her on twitter @donnaconsults.

Donna S. Robinson has been involved in the real estate industry since 1996. A licensed agent and real estate investor, she is a recognized expert on residential real estate investing. Her course, "Fundamentals & Strategies For Real Estate Investing" is approved for CE credit by the GA Real Estate Commission. She has authored several books on real estate investing, and consults with residential investment companies. She also offers coaching services to real estate investors.

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