The Latest in Eminent Domain: They’re Coming After the Banks

The latest trendy shtick being discussed, is the idea that eminent domain be used to take the mortgages of “underwater” homes. Under this approach, those mortgages (or perhaps more accurately, the notes secured by them) would be acquired at their depressed current market values, and the homeowner-motgagors would then be able to repay their mortgage debts at the lower levels, i.e., the true, lower market value in the current market rather than the inflated prices at which they bought them during the real estate “bubble.” See Tom Braithwaite, Investors Invoke Law to Solve Housing Crisis, Financial Times, June 10, 2012. The California city of Hesperia is actively considering suc h a scheme. Beau Yarborough, Hesperia Considers Using Eminent Domain on Underwater Mortgages, High Desert Daily Press, June 6, 2012,. Click on

While this would, in our opinion, be a lousy idea for a number of policy reasons, we are surprised it took so long for somebody to figure this out. After all, there is a market in mortgages, and when the mortgagees’ interest is taken by eminent domain there is no reason why they should not receive their secured notes’ fair market value as their “just compensation,” the same as holders of all other interests in the taken property, rather than the nominally outstanding loan balance which in the case of those “underwater” homes may not be collectable in the foreseeable future, or at all. Would such eminent domain takings be deemed a permissible “public use” within the meaning of the Fifth Amendment? Probably, given the current state of the right-to-take law. This would not be much of a stretch after Hawaii Housing Authority v. Midkiff which redistributed land titles from landowner-lessors to homeowner-lessees.

However, there are two obvious problems with such a scheme — at least they are obvious to us. First, the condemnor (envisioned as some sort of public-private entity) will have to come up with the money with which to pay for the reduced-value notes secured by those mortgages, before the affected homeowners will be able to pay off the new (reduced) debt in installments. Where will that money come from? Our hunch is that some sort of TIF-like revenue bonds will be issued (this is where the “public” part of that public-private partnership comes in) and sold to raise that money. Which may or may not be a good idea, being that everybody, including local government, is in hock up to the eyeballs, and what this may accomplish would be the creation of another, albeit smaller “bubble.” No one is going to do this as an altruistic gesture, and certainly the private end of any public-private partnership will want to make a profit. Why else do it? There are so many unknowns to all that — at least by our lights — that we don’t want want to go there right now. Just stay tuned and see what happens.

But there is another aspect to this idea that can have calamitous consequences. Remember that, though lots of mortgaged homes may be “under water,” the loans secured by them are carried on the banks’ books at levels of the original loans — this may be a fiction, but it is our admittedly inexpert understanding that this is how it is done. So when those mortgages are taken by eminent domain, and the prices paid to the banks for them are toted up, their value (now reduced to cash) will be much smaller that what the banks have been carrying on their books as the value of those loans. Will that development abruptly cause some banks at least to wind up with assets valued below the legally required minimum? Could be.

And don’t think that this is mere speculation on our part. We remember the S & L crisis of some years ago, where some perfectly sound S & Ls held large amounts of junk bonds that were paying interest at high rates like clockwork. And then, one day Uncle Sam changed the rules and demanded that those junk bonds not be deemed acceptable as S & L capital, so they had to be sold at fire-sale prices then and there. Result: some  otherwise sound S & Ls went under because after being forced to dump their junk bond holdings all at once in a depressed market, they wound up with insufficient capital.

Could that happen to some banks when the loans secured by mortgages on their books are abruptly re-valued downward in eminent domain proceedings? By our lights it could. When what up to then was carried on the banks’ books at their “bubble” values is abruptly down-valued to their shrunken, post-bubble values, there is no telling what the bottom line will be.

And remember that the end of our troubles in that field is not yet in sight. It could get worse. As we note from time to time, home prices out here in la-la land are still way too high, given what people are paid as wages and salaries, so a further downward “adjustment” in home prices is a distinct possibility. What then?

Remember that public economists and tycoons have enormous incentives to conceal or at least minimize the extent of coming bad news because being candid could cause a panic, and this is something no one wants. So it’s a good idea that all positive forecasts be taken with a bit of skepticism. At least that’s the way we see it.

In the meantime, if this scheme proceeds, we can look forward to more lucrative employment by condemnation lawyers many of whom could use the work.

Follow up. It turns out that Fannie Mae and Freddie Mac own or guarantee some 29% of underwater mortgages, but — guess what? — most of these borrowers continue to make their scheduled  payments, evidently hoping to hang in until the market recovers. But if you make a reduction in loan balance available, whether by eminent domain or otherwise, these people will be provided with a powerful incentive to stop making payments on their mortgages, hoping to get bailed out by the government. Which makes the proposed scheme a very bad idea.

For another point of view, explaining why such a bailout (albeit one without use of eminent domain) would be a bad idea, ranging from the cost to taxpayers (what else?), the limited number of benefitted homeowners, and the moral hazard of it, click here.

Second update. The academy has now weighed in on this subject. See Robert Hockett’s Cornell Law School Research Paper No. 12-12 — click here. We confess that our eyes glazed over when we came across the following passage in Professor Hockett’s paper abstract: “I argue  that ongoing and self-worsening slump in the primary and secondary  mortgage markets is rooted in a host of recursive collective action  challenges structurally akin to those that brought on the real estate  bubble and bust themselves.” Got that?

For a more detailed description of how this scheme would work (the restructured mortgages would be sold to — who else? — hedge funds) see the Huffington Post piece on this subject – click here.