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Eminent Domain to Address Foreclosure Blight

Adam Rust's picture

Posted August 10, 2012

The combination of underwater homeowners and the possibility that there are a substantial backlog of homes in sustained default which have not been foreclosed upon represents a major problem for some cities. But a proposal to fix that problem could de-stabilize the MBS market across the country.

In the last few weeks, several cities have said that they are considering using

the power of eminent domain to expedite the resurrection of their housing stock. The end result could be a win for underwater borrowers, huge returns for investors and steep haircuts for investors in mortgage-backed securities.

Yesterday, FHFA said that it would take comments on the use of eminent domain for this purpose. The comment period will remain open through September 7th.

The concept revolves around shifting obligations for these loans away from the banks that hold the loans over to the balance sheets of various municipal and federal governments. Cities like Chicago or San Bernardino would use their power of eminent domain to take residential properties. They would assume the debt, albeit after outstanding principal was reduced. The cost would be paid for with investor money. Shortly thereafter, the municipalities would arrange to refinance those loans into FHA. Most of the upside goes to the investors that supply the money. One estimate from a research firm suggested that investors could see returns of thirty percent on their investments.

Cities would have the ability to force investors to sell properties to a municipality at a "fair-market value" price determined by a court.

Chicago Alderman Edward Burke, a local proponent of the idea, has called for a hearing on the idea for this month.

The finances of Chicago and San Bernardino are uniquely poor. Nonetheless, the idea will remain tempting to the City of Chicago as long as there are more than 50,000 underwater homeowners sitting on loans of approximately that are upside down by as much as $37 billion inside Cook County.

But the real problems come down the road when market prices for MBS then fall. How much might those bonds sink? It depends on the exposure to risk. Bonds with concentrations in California - particularly some jumbos - would suddenly be at risk of huge losses. Moreover, the process would probably mean that investors take losses even when loans are current. Moody's predicted that in a sale, investors would see losses of about 15 to 20 percent. This might curb any recovery in housing prices.