There’s a new proposal out there to fight foreclosures, and it’s frightening banks.

The idea is to use government’s power of eminent domain – seizing private property for the public good – to snap up underwater mortgages at current market prices. This allows existing homeowners to refinance into much lower monthly payments, while leaving banks holding the bag.

The use of eminent domain to address foreclosures has taken off like a rocket since San Bernardino County in California announced earlier this month it was considering the deal. San Bernardino is working with a firm of former finance executives called Mortgage Resolution Partners (MRP), which includes a former director of residential lending at Bank of America.

MRP has also approached several other cities nationwide which have been hard hit by the foreclosure crisis. And the idea is already attracting attention in Washington: Rep. Brad Miller (D-NC), a member of the House Financial Services Committee, recently endorsed the idea in an op-ed in American Banker.

It’s picking up fans locally as well. A representative from Boston’s Department of Neighborhood Development asked Attorney General Martha Coakley to give her opinion on its feasibility in Boston at a conference last week. Coakley said her office had not examined the issue yet, but that “we’re open to all the suggestion that might make sense [to address foreclosures]. I think all of these ideas should be looked at.”
And if Coakley expressed guarded interest, homeowner advocates are downright enthusiastic.

“I and many other advocates working to stop foreclosures and keep people in their homes think it is a good idea and one tool that we should consider using to keep people in their homes,” said Nadine Cohen, managing attorney for Greater Boston Legal Services, an organization that often helps distressed homeowners secure loan modifications or other non-foreclosure solutions. “In some cities like Worcester and Springfield it would make a lot of sense – even in some parts of Boston.”

Determining Value

But the MRP proposal has critics – and not only among the financial services industry. The crux of the issue is how to determine “fair market value.”
In order to legally seize a property, the government must first prove it is doing so for a public purpose, and second must provide the owners with fair value in return.

Dwight Merriam, a partner at law firm Robinson & Cole in Hartford and author of Eminent Domain Use And Abuse, said it’s entirely possible that restoring blighted neighborhoods and shoring up the tax rolls might well meet the definition of a “public good,” though the idea remains untested in court.

But figuring out fair value for the mortgages might prove a bigger problem. MRP suggests that because bonds based on bundles of underwater mortgages are auctioned all the time on Wall Street, it ought to be simple to come up with a fair market price.

But critics point out that MRP’s plan is focused not simply on all underwater mortgages, but underwater mortgages in good standing, where the borrower is still making payments. Though it’s true that underwater borrowers are more likely to default in the future, so long as they’re making the payments, they might be a bank’s best customers: Since they bought their house during the boom, they’re paying higher interest rates. And since they’re underwater, they can’t refinance.
That means that simply looking at what similar homes have sold for or even what similar bonds have sold for might not be a good analogue for what a given loan means to a bank’s bottom line.

“Where there’s a sharp difference of opinion [about the value of a property being seized], they sometimes do go to trial and sometimes they come up with rather dramatic results,” Merriam said. And that is sometimes to the detriment of the government doing the seizing: Merriam recently worked on a case which ended up costing the state of New York $167 million.

Uncertain Future

“I think in the case of taking mortgages, we’d see a couple things happen. Because of the uncertainty of using eminent domain for that, and the problems with valuation, there’d be a lot of controversy,” which could potential result in legal battles, Merriam said. But even if the big banks are able to block seizures in court, smaller lenders might find themselves out in the cold.

“These cases are going to be particularly difficult to do as a class action,” Merriam said. “They’re going to have to do them one at a time. It’s like tax appeals – the cost of lawyering may well exceed the additional value they get for compensation.”

It’s still unclear whether eminent domain seizure will ever get off the ground. As yet, no mortgages have been seized in San Bernardino, and the county seat’s recent declaration of bankruptcy may have permanently pushed it to the back burner.

But the mere possibility already has Wall Street up in arms. The American Securitization forum declared in a letter to San Bernardino County that seizures “would undermine the national market as a whole, making credit less accessible for homeowners and devaluing the investments of pension funds, mutual funds and other entities that hold mortgage-backed securities.”

More drastically, the Securities Industry and Financial Markets Association declared that its members would not accept mortgages for securitization from any city or county which used eminent domain – a threat that could potentially cripple the mortgage market in those areas.