Can Eminent Domain Save Underwater Homeowners?

Eminent domain may be a way for the government to help homeowners with underwater mortgages.

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A bank-owned home.

John Vogel is an adjunct professor at Dartmouth's Tuck School of Business.

In San Bernardino County, Calif., half of the houses are "underwater," meaning the houses are worth less than the amount owed on the mortgage. Greg Devereaux, the county's chief executive officer, is considering using eminent domain to help solve this problem. As Joe Nocera wrote in his July 9, 2012, New York Times column, "When you first hear this idea, it sounds a little crazy." However, Nocera goes on to say, "the more closely you look at it, the more sense it starts to make."

The Fifth Amendment to the U.S. Constitution gives the government the right to take private property for public benefit as long as it serves a "public use" and there is "just compensation." The most common uses of eminent domain are for building or expanding roads, subways, and utilities. For example, New York City used eminent domain to secure the subsurface rights to over 1,800 properties in order to construct a tunnel for its water system.

In addition to the federal and state governments, many local authorities can take property by eminent domain. In Texas, 90 different entities have this power. In Virginia, 40 agencies can take property through eminent domain. Let me provide an example of how eminent domain might work with underwater housing: Assume that Mr. Jones owns a house that is currently worth $200,000 and has a mortgage for $300,000. The government entity could take the house through eminent domain. It is required to pay just compensation which is the value of the house or $200,000. The $200,000 payment would then flow through to the mortgage holder. The government could then sell the unencumbered house back to the homeowner for $200,000 and either provide a mortgage or have the homeowner get a traditional mortgage. Some schemes have the government entity seizing the mortgage, instead of the property, at a substantial discount, but I think that may be less beneficial, especially since so many of these properties also have second mortgages.

[See a collection of political cartoons on the economy.]

Should San Bernadino County or some other agency use the power of eminent domain to deal with the problem of underwater houses, I see five significant positives and five significant negatives to this concept. The key positives are:

  1. It can happen immediately. San Bernardino County can seize underwater houses tomorrow. It does not have to wait for Congress to pass legislation or the lenders and special servicers to consent.
  2. It is a local solution. What works in San Bernardino County may or may not be applicable to Cleveland. Each locality can determine the criteria for deciding which houses to acquire.
  3. There is an objective value. In the example above, the $200,000 value for the house would come from an objective appraisal of the property.
  4. It deals with the second mortgage problem. A significant percentage of underwater houses have second mortgages. In the example above, there might be a $50,000 second mortgage on top of the $300,000 first mortgage. One would expect the lender to write off this second mortgage as a bad loan, but instead, lenders have found that by holding out, they may be able to get something for their worthless second mortgages. Once the property is taken by eminent domain the second mortgage lender no longer has the house as collateral.
  5. Most importantly, the threat of eminent domain will bring the parties to the table and force something to happen. Most of the time, the government and the property owners work out an agreement without going through the eminent domain process.
  6. [See a slide show of 6 ways to fix the housing market.]

    On the other hand, eminent domain is a blunt instrument and there are at least five negatives to using it.

    1. The process is complicated. Each house and each homeowner has unique attributes. Trying to design a simple, efficient, and fair process will be challenging. The process may become cumbersome and bureaucratic.
    2. Mistakes will be made. Some people will get benefits they do not deserve. Also, appraisals rely on someone's judgment and some appraisers will value homes incorrectly.
    3. The government will be placed in an uncomfortable position. A mortgage is a private contract between a homeowner and a lender. In general, the government should not interfere with private contracts.
    4. Obtaining money to create and support this program will be hard. San Bernardino County just declared bankruptcy. Most of the places that have a lot of underwater mortgages are also stretched financially and will have a hard time floating bonds or otherwise obtaining money to buy the properties.
    5. The proposal from Mortgage Resolution Partners to the County of San Bernardino is deeply flawed. Joe Nocera's column focuses on a specific proposal by Mortgage Resolution Partners, known as MRP,  that uses eminent domain to purchase performing loans at a discount. This does not really help most underwater homeowners. As Robert Kuttner points out in his column in the Huffington Post: "Who needs MRP as middleman? By skimming off only the best mortgages, it is taking almost no risk and stands to reap windfall profits for raising capital and shuffling paper."
    6. [Read the U.S. News Debate: Should the Government Help Homeowners With Underwater Mortgages?]

      There are a number of policy proposals that might work better than eminent domain. For example, changing the bankruptcy laws so that mortgages are treated like other forms of debt might be simpler and fairer, and would probably produce better results. But that would require an act of Congress.

      We are now four years into the housing crisis. To date, all of the programs designed to help homeowners have been "voluntary to the lender" and have failed to make much difference. As Brad Miller, a congressman from North Carolina wrote back in February 2010 in The New Republic advocating the use of eminent domain: "Every government foreclosure mitigation effort so far has depended entirely on carrots for the industry, usually designed by the industry itself. …Eminent domain will provide foreclosure mitigation efforts with a badly-needed stick."

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