The idea of using eminent domain to help homeowners who own property worth less than the value of their mortgages, has become more and more popular in the past couple of weeks. Eminent domain allows the government to seize an individual’s property at market value if it is used for the public’s benefit. The Founders included it in the Constitution so that the government would not have to bargain with individual landowners for their property if it needed to make public improvements.

Felix Salmon has written about it three times, supporting the idea, but not its implementation in San Bernardino County, California. The idea originated in San Bernardino, but has gained more press recently with Representative Brad Miller writing an op-ed on it in American Banker Wednesday and Joe Nocera endorsing it in the New York Times recently. If enacted, the policy has the potential to significantly help millions of homeowners who cannot pay their mortgages. However, while the idea works in principle, using eminent domain would have the unintended and negative consequence of increasing housing prices.

Here’s how it works:

Many homeowners around the country are unable to afford their loan payments and their mortgages are worth more than their homes (nearly a third of mortgages are underwater). Banks require the value of a home to be greater than the value of the mortgage in order to refinance. Thus, these homeowners are not eligible to refinance. If the bank were to reduce the principal on the loan so that the value of the mortgage fell below the value of the home, then the homeowner would no longer be underwater, could refinance and might be able to pay back the bank at the new rate.

However, banks are not just going to reduce the principal. This creates an incentive for homeowners to default on their mortgage payments in order to get cheaper mortgages.

But some outside companies, such as the hedge fund American Home Preservation in California, saw an opening. They could purchase the defaulted loans from the banks, which are not collecting anything on the mortgages and will have to spend money to foreclose on the homes, below market value and then reduce the principal for the homeowners. Then, homeowners can refinance and afford their payments.

Under this process, the bank gets to remove the mortgage from its balance sheet and not have to deal with the foreclosure process. The outside company earns a profit by purchasing the loan at a slight discount and restructuring it at market value. The homeowner keeps his home. Everyone wins.

The problem is that this proposal does not work when banks have securitized the loans. This means that the loan is cut up into different pieces called tranches. Each tranche is then combined with tranches of other loans and sold as a bundle (a security) to investors. In order to lower the principal of the loan (and allow the homeowner to refinance), the company would have to purchase every tranche of the loan. (There are about $8.41 trillion in mortgage-related securities outstanding; 62.3 percent of mortgages are currently securitized.)

A company seeking to purchase a loan must track down all of its owners and make sure they are all willing to sell. This is easy when the bank has not securitized the loan and holds the entire thing, but when it slices the loan into tranches and sells it to investors, the strategy is costly and difficult. If one owner refuses to sell, the entire deal falls apart and the company is stuck with whatever tranches it has already purchased. Thus, no company will ever attempt to carry out such a plan..

Salmon, Nocera and others want to use eminent domain to fix this problem and force force everyone who owns parts of the loan to sell the tranches at market value to sell to a hedge fund like American Home Preservation.

This is unchartered territory for a government using eminent domain, but works in the same manner. The government would use eminent domain on to require the holders of every tranche of a loan to sell at market price.

In principle, using eminent domain removes any risk that investors won’t sell the tranches at fair value. In addition, it should not anger banks and investors, because they are not making money off these underwater houses anyway and will lose money foreclosing on them.

“[T]he more closely you look at it (using eminent domain), the more sense it starts to make,” Nocera writes. “It would be a way to break the logjam that keeps mortgages in mortgage-backed bonds — securitizations — from being modified. It could prevent foreclosures. And it could finally stabilize housing prices.”

But this is misleading. The primary problem with using eminent domain to seize mortgages is that it actually introduces more uncertainty into the housing market. If investors know that the government can seize their security at any time, they are going to demand a higher rate of return to offset that risk. In the end, the homeowners would end up paying higher interest rates and houses would become more expensive.

On paper, the plan makes sense if all actors involved are in favor of it, but even so, it still sets a principle that the government can use eminent domain to seize an investor’s security at any time, leading to greater risk for investors and higher prices for borrowers.

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Danny Vinik

Danny Vinik is an intern at the Washington Monthly.