Eminent Domain on My Mortgage--Really?

  • Posted by Preston Howard
  • July 19, 2012 4:50:57 PM MDT

Normally, one would expect that property seized in eminent domain proceedings is purchased and subsequently demolished for the purpose of the public good, (for public roads, schools, and college expansion), but not in this case...

Eminent Domain on My Mortgage--Really?

Recently, I heard the most interesting news. Officials in various California cities are planning to apply for eminent domain to the underlying mortgages of homeowners within their municipalities. According to the online legal dictionary, eminent domain is “the power to take private property for public use by a state, municipality, or private person or corporation authorized to exercise functions of public character, following the payment of just compensation to the owner of that property.” The practice of eminent domain has occurred to make way for freeways, schools, and railroads. However, in this instance, the premise is to help borrowers who owe more than the value of their homes.

Normally, one would expect that property seized in eminent domain proceedings is purchased and subsequently demolished for the purpose of the public good, (for public roads, schools, and college expansion), but not in this case. Officials in San Bernardino and Ontario are vying for homes that once were worth $350,000 with a mortgage of $310,000, but now are valued at half of their original amount. Accordingly, these cities seek to obtain court approval to force the sale of the mortgages at a discount to their current balance. You can imagine that cities are taking a “sign me up” type attitude, while current mortgagors, servicers, and investors are crying foul as their investments are in danger of being halved.

While one investment bank (Mortgage Resolution Partners) believes the political climate is right for the program, the underlying stakeholders may not agree. Sure, there are some hedge funds representing a variety of high net worth individuals, which own billions of dollars of “paper,” (securities speak for mortgages), but many pension funds representing white and blue collar workers, teachers, first responders, clerks and in some cases, employees of the municipalities in question, have their retirement funds tied up in mortgages backed securities. A portion of their retirement funds is at stake, so a city can’t just casually invoke eminent domain without backlash. For one, it’s unprecedented. Two, case law supports the acquisition of land and homes, but not the underlying mortgage which is not the asset of the homeowner. These municipalities are going forward without public funding, so they can only be corralled in the courthouse, and that is where this issue appears to be going.

Now, mortgage investors off all stripes are ready to fight this issue. To them, a mortgage loan was made fairly and by the prevailing rules of the land; accordingly, they deserve a return of all of their capital as agreed. Anything less is a heinous crime. The backlash of a victory for eminent domain would be the reduction in the availability of capital in the San Bernardino and Ontario markets on a go-forward basis. Who wants to lend in a city that seizes mortgages and arbitrarily reduces the balance of the investment by half? The answer is no one. In the end, eminent domain could lead to the enactment of selective lending on a city-by-city basis.

Do I see eminent domain making a dent in these cities? No, I only see it in court. The stakeholders will have their day in court to force these cities to capitulate. Two of California’s largest pension funds are the State Teachers Retirement fund and the Public Employees Retirement fund. Both entities have a history of buying mortgages, just like so many other mutual funds, hedge funds, pension funds, and private equity funds like KKR and Blackstone Group. I can imagine a fight from the latter two entities while the former two would not. However, with over $200 Billion in assets actively invested for each fund, I can see political battles brewing.

In the end, should a city use eminent domain for the betterment of its citizens? Yes, absolutely; for roads, schools, and betterment of the public good. Should it be done through the improper acquisition of someone’s land at a fraction of the original price? Absolutely no. I’m quite interested to see how this issue will be resolved in Southern California. I’m not sure, but if eminent is allowed to stand on underlying mortgages, expect a change in lending not just from state-to-state but city-to-city; oh what a quagmire that will be.

Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance, he can be reached at howardpr@rosecityrealtyinc.com.