Prices are soaring in the blue-collar Bay Area suburb. The Zillow.com home price index is up 33.7 percent this past year in the city, reducing the number of homeowners who owe more on their loans than their homes are worth. And some homeowners have already gotten help. Twenty percent of all Richmond homes with underwater loans have had the principal on their loans reduced as of January 2013.

Nevertheless, on July 1, the Richmond City Council voted 4 to 3 to use eminent domain to seize 624 underwater mortgages it has identified from private mortgage lenders so as to prevent future foreclosures.  But to pursue condemnation of the mortgages, the council needed a two-thirds majority, or five votes, making the 4-3 vote symbolic, not binding.

The Richmond council members want their city to partner with another city to form a joint powers authority to reduce the legal and administrative costs involved. But other cities appear wary for many reasons, starting with the fact that San Bernardino and North Las Vegas abandoned using mortgage eminent domain after concluding it would severely harm their real estate economies because lenders would stop making home loans.

Most knowledgeable eminent domain experts don’t believe mortgage eminent domain will meet the legal tests required that such actions can only be undertaken for a broad, necessary public purpose — such as seizing land to build a dam or a police station.

The four council members say they are trying to help constituents who can’t get help from the state or federal governments.

A double-whammy on property taxes

Zillow.com reports that 27.8 percent, or 7,584 homes, in Richmond had negative equity as of March 31, 2014.  The median home price during the mortgage bubble was about $444,000 compared to $314,250 today.  That $129,750 gap could mean nearly $1 billion in negative equity in homes, reflecting a potential property tax decline of $10 million a year.

To compound Richmond’s loss of property tax revenues from over-mortgaged homes, its school districts lost 14.61 percent of their property tax revenue this past year due to the August 2012 Chevron refinery fire, and the city lost $6.1 million in revenue.

“Richmond’s decline was driven largely by the change in the refinery’s valuation. County Assessor Gus Kramer said his office valued the Richmond refinery at about $2.75 billion in 2013-14 compared with around $3.75 billion the previous year. The city as a whole was given a net assessed value of $10.89 billion, a decline of more than $1.86 billion; every other city in the county saw an increase in assessed value,” the Contra Costa Times reported in July 2013.

Chevron paid $2 million in fines after the city sued Chevron for costs of fire, police, environmental clean-up costs.

By Wayne Lusvardi

When did the California Dream begin?

Peter Huck, a refugee journalist from Los Angeles to New Zealand, has an answer. He writes in the July 20 issue of the New Zealand Herald newspaper “Sustainability Reinventing California Dream” that the California Dream began when Los Angeles Department of Water and Power’s William Mulholland said at the 1913 opening of the California Aqueduct: “There it is, take it.”

Huck believes that “sustainability” will lead to an economic recovery in California.

But the California Dream may have ended with California’s Anti-Sprawl Law, Senate Bill 375, which Huck champions in his article as an economic stimulus to get the state out of a managed depression.

More recently, the County of San Bernardino in California has proposed to use eminent domain to condemn mortgages on “over-mortgaged” homes.  The county would do this by spreading about 30,000 over-mortgaged loans to all 699,000-property owners in the county by way of additional property taxes.

If there is a new slogan for California nearly 100 years after Mulholland’s epic statement, it is: “Socialize losses and privatize gains.”  Which is another way of saying: “Everyone wants out of bubble-created debts, but no one wants to pay for them except through more bubbles.”

Yet no one in San Bernardino has apparently realized that reducing the over-mortgaged portion of home loans will just lower assessed property values and drastically reduce property tax revenues.  Mass delusion is starting to spread across desperate California just as the Tulip Bulb Mania, the South Seas Bubble and the Mississippi Bubble followed the debt bubbles of the 1700’s in Europe and early America.

“Sustainable” Transit Will Result in Unsustainable Water

Having handled land use for a regional water agency in California for 20 years, I find that Huck has focused on the ideological level of explanation, rather than the empirical.

Contrary to Huck, steering population and housing into coastal cities in California will result in an unsustainable use of water resources.  Infill housing near urban job centers may result in fewer auto emissions from auto commuting.  But diverting population growth to dense urban cities will also force greater reliance on imported water supplies from the Sacramento Delta and the Colorado River.  California’s cities depend on groundwater for about one third of their water during dry years.

What has historically made water valuable in California has been the relative cheapness of water from urban groundwater basins compared to expensive imported water.

The anti-sprawl law will require that cities adopt sustainable growth plans to shift new development from the urban fringe, where groundwater resources are more abundant, to highly dense urban areas, where local water supplies are patchy and often polluted from war time industrial toxic wastes.  It would take decades, if ever, to clean up polluted urban groundwater basins.

Viewing a map of groundwater basins and a map of housing density for California indicates that water and populations are not geographically proximate. The densest populated areas are mostly along the coast while most groundwater resources are inland.

Moreover, by virtue of shifting to reliance on imported water supplies, California will need to buy more imported electricity to pump that water to urban centers located far from the sources of water.  Will expensive Green Power mostly be used to pump water long distances?  Or will Green Power be dedicated to powering the proposed California High-Speed Rail Authority?

Solar power can only be used in mid-to-late daytime; while wind power mostly peaks at night.  But neither can be relied on for non-peak load power uses — homes, industries, hospitals, and public transit — because they are unreliable and thus unsustainable.

How Cal Energy Crisis Resulted in “Sustained” Drought

In 2001, this writer was a member of an Energy Crisis Task Force for a large regional government water utility.  The original cause of the California Energy Crisis of 2001 was the 1996 Federal Environmental Protection Agency “mandate” to California to clean up urban smog by 2001 or face a cut off of highway and education funds.

The only way to comply with the federal mandate was to shut down old polluting fossil-fuel power plants along the California coast owned by Pacific Gas & Electric, San Diego Gas & Electric, and Southern California Edison companies.  Then these obsolescent power plants had to be divested to private operators and converted to cleaner natural gas fuel power plants.

California was not running out of energy in 2001; it was running out of clear sky.  The real crisis was not energy, but how to pay off the old stranded or “underwater” mortgages — called corporate bonds — on the mothballed power plants. Everybody wanted smog eliminated, but no one wanted to pay for it.  Federal environmental policy became “clean air at any cost.”

The initial energy crisis solution in 2001 was to give a quasi-monopoly to natural gas suppliers, mainly in Texas, to try to pay off the bonds on the old power plants. This policy was erroneously called “deregulation,” which failed. The plug was pulled on deregulation by the Democratic legislature and governor and replaced with a system of energy price caps.

Retail electricity prices were eventually capped; but wholesale energy prices were not resulting in an induced energy pricing fever. This bubble in energy prices was intentionally created to pay off the unpaid mortgages on the mothballed power plants.  But it also failed miserably and even resulted in some fatalities.

Finally, some $42 billion in mortgages were paid off by energy price premiums loaded into long-term energy contracts mainly to run the pumps for the California State Water Project.  Smog reduction was paid for by inflated water rates.

By 2007, a man-made drought resulted from an environmental lawsuit to protect the purportedly endangered Delta Smelt fish in the Sacramento Delta. In 2010, an appeals court ruled that the allegation that the Smelt was endangered was bogus.

By manufacturing a drought, California not only protected a bubble in water rates that securitized the pay off of long-term bonds to reduce smog, but also brought about even higher water rates. These higher local water rates have not been repealed anywhere in California after the court-ordered drought was ended in 2010.

California Politician’s Dream Come True: “Taxation without Representation and Limitation”

Loading the cost to clean up the air into water contracts avoided having to go to the California Public Utilities Commission for an electric rate increase, to the Legislature for a tax increase, or to the voters for the approval of a tax increase, as required under Proposition 13.  To politicians, it was a California Dream come true: ”taxation without representation and limitation.” But it led to economic stagnation.

Long-term water contracts expire in 2013, when AB 32, the California Global Warming Solutions Act of 2006, kicks in.  In other words, in 2013 California will no longer pay premiums loaded into the price of water to pay off the cost to reduce smog.

But a replacement premium will be added to electricity rates to pay for the mandatory shift to expensive Green Power.  Solar and wind power located in remote areas is supposed to reduce urban air pollution but will add transmission costs.

This will prevent the building of new conventional power plants in urban areas where smog is trapped in urban air basins.  It isn’t solely pollutants that cause smog, but the trapping of pollutants in air basins.  The solution to pollution is dilution and dispersion — not anti-sprawl legislation that will concentrate more people in dense urban air basins who will travel to work in bullet trains subsidized by Cap and Trade taxes disguised as a pollution emissions market.

Moreover, back up conventional power plants will have to cycle up and down as the sun shines or clouds cover the sun and the wind gusts. Power-plant “cycling” will cause more air pollution as surely as pushing your gas pedal up and down constantly in your car or frequently moving your home thermostat will do the same.

The California Energy Crisis of 2001 ended up loading the huge cost to reduce smog into premiums in water rates.  That, in turn, resulted in the necessity of an artificial drought.  Instead of building more dams, reservoirs and pipelines, the only way left to manage water supplies was by conservation. California had to protect its water-rate bubble, and thus had to squelch any new water development or water markets for over a decade.  It needed a “sustainability” ideology to legitimate its conservation policy.  “Sustainability” is just public “hucksterism” if you will forgive the pun.

California may finally put an $11 billion water bond on the election ballot in 2014, coincidentally after the bonds on the California Energy Crisis of 2001 are paid off.

The Solution to Bubbles is Not More Bubbles

In Michael Lewis’ pop economics book, “Boomerang: Travels in the New Third World,” he describes the blowback from Greece’s debt-created bubble.  All Greeks wanted the national debt reduced, but nobody wanted to pay for it.

Greece tried to load its unpaid national debt into electric power rates.  This only resulted in ratepayers refusing to pay their electricity bills and falling revenues for the state utility agency.  The result was power blackouts, disinvestment by the bond market and social and political destabilization.  Should we expect anything less from California’s loading of the cost to reduce air pollution in water rates securitized by water conservation and legitimated by a “sustainability” ideology?

Contrary to Peter Huck, a “sustainability” ideology will not result in an economic recovery for California. The future of California’s economy is more likely to be slow growth due to having to pay down the private sector mortgage-debt bubble and the public sector’s pension, redevelopment and air quality-water rate bubbles.

Creating new tax bubbles by condemning “underwater” mortgages, by Cap and Trade “tax farming,” and by inflating Green Power rates, will only assure the older bubbles will be replaced with new ones.  California band musician Lawrence Welk famously invented “the Bubble Machine.” But perhaps comedian Stan Freberg was prophetically right when he recorded his spoof of the Lawrence Welk Show by saying it was time to “turn off the bubble machine?”

by Wayne Lusvardi

A few hundred years ago there was the famous Dutch Tulip Mania of 1637. It was followed by the South Sea Bubble of 1711 and the Mississippi Company Bubble of 1719.

In modern times, there was the California Energy Crisis of 2000-01, with its energy bubble caused by government price caps. Then there was the U.S. sub-prime Mortgage Bubble of 2003 to 2006, centered in California.

Now there is the mania of the San Bernardino County Joint Powers Authority to seize “underwater mortgages” on homes through the use of eminent domain.

The county’s proposal calls for a joint public-private partnership to be formed with a private mortgage company to reduce the amount owed on “underwater mortgages.”  Underwater mortgages are where the amount owed on a home loan is way more than the current market value of the home.

All the loan reductions would be rolled into a municipal bond to spread the cost of over-mortgaged properties to all property owners in the county on their property tax bill.  It is assumed that losses could be socialized; but gains in property value would still be allowed to private property owners.

Hope and mass delusion spring eternal when people are economically desperate. And San Bernardino homeowners with “underwater mortgages” are understandably desperate and prone to being misled by loan sharks. Only in this case the government is inviting the loan sharks into San Bernardino County, just as they did with the sub-prime Mortgage Bubble.

A Homeowner ‘Steering’ Committee

Homeowners are apparently being misled by the news that the county plans to use eminent domain to reduce the loans on their over-mortgaged properties. They have now formed the San Bernardino Homeownership Protection Program to steer San Bernardino County to rescue their over-mortgaged properties and not to have those mortgages picked by some other process.

David John of the Heritage Foundation reports that, at most, only about 20,000 to 30,000, of the 150,000 underwater mortgages would be considered for the proposed loan write down program. For the higher figure, that’s about 20 percent.  As we can already see the selection of who gets such loan reductions would be prone to being politicized.  Will loan reductions be “blue-lined,” just as mortgages were purportedly once denied to minority neighborhoods by “redlining?” 

How Homeowners Are Misled

Here is how Kathleen Pender, the personal finance and investing columnist for the San Francisco Chronicle, understands such a loan-reduction program would work:

“Suppose a homeowner owes $300,000 on a home now worth $200,000. The city seizes the loan and pays the current mortgage holders $170,000. This price assumes a large number of severely underwater homeowners will ultimately default. The city, which now owns the loan, writes down the balance to $190,000. Now instead of being underwater, the borrower has $10,000 in equity. He gets a new loan for $190,000, which pays off the $170,000, with $20,000 left over for the city to share with its investors and pay expenses.” 

Pender’s above example is mistaken, however.  Homeowners would not be allowed $20,000 in “equity” or price appreciation upon re-sale of their home. Government can socialize losses, but they cannot privatize gains.  A knowledgeable person like Pender is even misinformed as to how this program would work.  When even the experts are misled, it is no surprise that homeowners are deluded that there is some magic wand that government could wave to get rid of the excess mortgages on their properties and allow them to reap a small profit.

Profit on Loan Reductions Forbidden

I previously worked for a public housing authority and did many loan write-downs for low-income and affordable housing programs.  The standard practice was to require homeowners to agree in writing to give up any future value appreciation in their home as a condition for receiving a loan subsidy. This is also how the popular semi-private homeownership program called Habitat for Humanity works. Kurt Eggert, professor of law at Chapman University, has additionally said that homeowners would be forbidden from making a profit on any loan reductions for properties in foreclosure or with underwater mortgages.

The U.S. Subprime Home Loan Bubble of 2003 to 2007

We’re still suffering from the collapse of the mid-2000s subprime home loan bubble and resulting bank panic. The bubble was created by government to compensate for a huge loss of jobs resulting from a relative demographic decline of intact families to take out enough home and small business loans to support pensions and Medicare for the elderly.

Government policy “mandated” that renters take out sub-prime loans and become homeowners to prop up pensions and government medical care.  Obamacare is just another form of such a “mandate” to prop up pension and medical subsidies, only now it is called a “tax” because of the July 28 U.S. Supreme Court Ruling. This demographic imbalance is the same problem that has caused the economies of Greece, Spain and other European countries to collapse.

Bubbles, manias and Benito

San Bernardino has falsely promised homeowners with underwater mortgages that they can have their cake and eat it too; that they can reduce the over-mortgaged loans on their now deflated home values and can have some small amount of equity and future home price appreciation at the same time.

Even if implemented, such a loan reduction program would lead to yet another false bubble economy and crash.  Government cannot load the over-mortgaged portion of everyone’s home loan in California into a hidden premium in energy or water rates, as it has with Green Power to pay for smog reduction.

California has ended up with a man-made permanent water drought as an unintended consequence of cleaning up smog from urban air basins by loading the cost in inflated water rates.  San Bernardino County will unintentionally end up with permanent economic drought and stagnation if it should be able to figure out a way to legally justify the socializing of over-mortgaged properties by eminent domain.

Lenders would avoid making home loans in San Bernardino. And the bond market would be afraid to invest in San Bernardino for fear that bonds would be confiscated by government via eminent domain.  A system of gambling in home loan derivatives would be introduced to the San Bernardino real estate market, just as California allowed casinos on Indian Tribe lands in the Inland Empire.

California would more resemble Mussolini’s fascist Italy, in which business and government colluded, than it would a free market economy.  The home loan market in San Bernardino would be stigmatized as the first in the U.S. with socialized mortgages.

By Wayne Lusvardi

What a ripoff. San Bernardino County wants to use eminent domain to let a private mortgage lender cherry pick “underwater” mortgages without paying damages to the lenders. Doing so supposedly would stimulate the resale market for homes.

The county’s policy would socialize the losses and privatize the gains of the underwater mortgages.  This would be done by acquiring underwater mortgages by eminent domain and re-selling them in the mortgage market for a discount.  Essentially, all taxpayers in the county pay would pay off the difference between the full acquisition price and the re-sell price through a municipal bond. The private mortgage company working for the county would make a fee from each sale.

Phil Angelides Previously Headed Mortgage Company

Mortgage Resolution Partners is the mortgage company selected by San Bernardino County to resell underwater home mortgages.  This company was recently headed by Democrat Phil Angelides, the former state treasurer lost a bid for governor in 2006. Angelides also was the chairman of the national Financial Crisis Inquiry Commission that mainly blamed banks, not government, for the 2007-09 economic crisis.

Angelides was also the co-developer of a residential subdivision called Laguna West in Elk Grove outside of Sacramento. Trulia.com reports there are 24 foreclosures and pre-foreclosures for re-sale in Laguna West today.

I’m no lawyer. But as an eminent domain appraiser for over 20 years, I would find the county’s proposal to condemn only “underwater mortgages” where the homeowner is still making payments as a likely violation of the legal rules for appraising just compensation in California.

The Entire Loan Portfolio Needs to be Valued

The mortgages to be acquired by eminent domain would have to be valued by appraisers for their “Fair Market Value.”  What would be appraised would not be the physical, tangible real estate of each home.  What would be appraised would be the intangible value of the underwater mortgages. An underwater mortgage is where the unpaid portion of the loan on the property exceeds the current open market value of the home.

The loans would have to be acquired for their remaining loan balance in order to make the lenders whole. Mortgage brokers or experts, not real estate appraisers, would subsequently be asked to value the mortgages for re-sale.  The mortgages would be valued not on the basis of the “comparable sales price” of actual homes, but the discount rate paid by mortgage brokers in the mortgage market.

According to securities expert and commercial real estate appraiser Steve Body of Eagle Rock, the discount is likely to be in the 50 to 60 percent range. This discount would have to be paid for by all county property taxpayers through a bond. Only the intangible loan value of the mortgages would be taken, not the physical real estate of each home with an underwater mortgage.

To comply with accepted “before and after” valuation methodology under eminent domain law in California, a condemning agency must retain an independent appraiser to value the “larger parcel” of the property to be taken.

For example, an agency may only want to acquire the farmer’s field. This is what is called a “part taking.”  But what has to be valued is the entire farm, including farm buildings, water wells, water rights, crops in place, chattels, any vertically integrated “ongoing” businesses, etc.

The same rule would likely apply in San Bernardino’s situation.  The “underwater” mortgages are part of a larger portfolio of loans.  Whole loan portfolios are valued in the private sector by discounting the cash flow from loan payments to their present value.  Loan portfolios likely have a mix of loans that are “not performing” (loan payments are in arrears) and loans that are “performing” (owner is current on payments).

As I understand it, what San Bernardino wants to do is cherry pick the best performing loans and leave the lenders with the loans that have been given Notices of Default and are in the process of foreclosure.  In short, they want to cherry pick the top of competitive lenders mortgage portfolios — all in the name of the “public interest.”

As many legal experts have stated, there is likely no doubt that the county has the right to define what is in the “public interest.”  The county can likely establish that it can take mortgages and allow a private lender to make a profit on them by reselling them.  This would be like taking someone’s home and allowing a private developer to upzone the land and make a profit on the higher use of the property for redevelopment.

But the county would have to re-write the Code of Civil Procedure and case law in California if it thinks it just wants to value those mortgages that are underwater and not the entire loan portfolio of the lenders.  This would be a gargantuan task because the county would have to appraise the entire loan portfolio of every lender, not just the 5,000 underwater mortgages it plans to take. We’re talking about countless thousands of loans valued as of a specific date. And the holders of the loans would have to be tracked down and identified, which may be an impossible task.

Severance Damages Also Need to Be Valued

Even if the entire loan portfolio could be valued, any “severance damages” to the remainder of the loans would also have to be appraised. The intent of just compensation is to “make the property owner whole,” not only for the property taken but also for any damages.

To use a farm example again, any damages to the remainder of farmland would have to also be appraised in addition to the value of the land taken.

As commenter Michael Baldridge appropriately wrote in the Wall Street Journal online:

“They want to seize the note. The note is worth what the note says. It’s the underlying collateral that is worth less. If they want to ‘seize’ the mortgage, they’ll have to pay the owner market value of the note, which is whatever is left on the mortgage. The underlying collateral is irrelevant. Using Mortgage Resolution Partner’s logic, the government could seize the note on a new car the second it drove off the lot, and the car is now worth 10% less. Then sell the car back to the owner for a 10% lower price (and lower payments), taking all the future payments while sticking the car dealer with the loss.” 

If the county cherry picked the best loans, then it would have to pay any damages to the remainder of the lender’s loan portfolio.

According to Body, if the county’s action results in leaving a greater proportion of non-performing mortgages in the lender’s loan portfolio, this would likely alter the portfolio to a status of “junk” (B-minus or lower credit rating).  The overall loan-to-value ratio, the percentage of under-performing loans, and the default rate would also have to be considered.

Uneconomic Remnant

If the remainder of a lender’s loan portfolio became unmarketable or worthless due to the county’s actions, the remainder of the portfolio could be deemed an “uneconomic remnant.” 

The term uneconomic remnant means: “a parcel of real property in which the owner is left with an interest after the partial acquisition of the owner’s property”; and which the government agency “has determined has little or no value or utility to the owner.”

In such an event — where the portfolio remainder has no value — the county could be legally compelled to acquire the whole portfolio.

Inverse Condemnation?

There are many other flaws in the notion to use eminent domain to acquire underwater mortgages to re-stimulate the housing market in San Bernardino.  Another of them is that such an effort is likely to impair the market value of properties for sale with no mortgages on them — where the homes are owned “free and clear” of any mortgage.  Bailing out the figurative water from “underwater” mortgages would flood the market with too much of a supply of homes, resulting in a decline in value.  Fire-sale prices would likely result as the pent up demand to sell previously over-mortgaged homes would flood the market and depress prices further.  The value of non-mortgaged homes would likely be dragged down along with the value of previously over-mortgaged homes.

This could give rise to what is called an “inverse condemnation” or “regulatory taking” lawsuit, where the property owner sues the government for a loss in value.

Fatal Flaw in County Proposal

Having to pay “severance damages” could be a fatal flaw that would likely make San Bernardino County’s proposal to acquire “underwater mortgages” economically infeasible and politically unacceptable.

If damages also had to be paid, the private loan reseller for the county would be unlikely to be able to make a profit.  Another option would be to have all property taxpayers in the county additionally pay for any damages to the remainder of the lender’s loan portfolio, as well as the underwater mortgages. Taxpayers might be outraged to have to pay damages as well as having to pay for what constitutes a gift to homeowners with underwater mortgages.

And if any homeowners file an additional lawsuit for “inverse condemnation” damages for impairing the market value and marketability of their homes, this could result in the county having to pay double damages to both the mortgage lender and third-party homeowners who couldn’t sell their homes.

San Bernardino County would be wise to ask the office of Attorney General Kamala Harris to issue a preliminary ruling of whether such a use of eminent domain is legal. And if so, the attorney general’s office should indicate whether the county would have to comply with the State Eminent Domain Code and the State Rule of Appraising Partial Acquisitions of property.

Advice also should be asked of eminent domain legal experts such as Gideon Kanner.

With San Bernardino city just declaring bankruptcy, and even faces a criminal probe, San Bernardino county shouldn’t compound the area’s economic problems.

By Wayne Lusvardi

In San Bernardino, the county has approved using eminent domain to seize bank-owned pools of “underwater mortgages” to get the county out of its over-indebted housing stagnation. The city of San Bernardino has the second highest poverty rate in the United States, after Detroit.

The cities of Fontana and Ontario have also approved joining the program.  The city of Hesperia, however, rejected the idea.  But such a bailout of underwater mortgages is likely to result in a number of foreseeable negative unintended consequences.

What happens if the county buys up underwater mortgages, but home values plunge again due to a double-dip recession triggered by an economic disaster, perhaps the European debt crisis? Economist Gary Schilling, who has called every recession correctly since the 1970s, is forecasting another 20 percent drop in national housing prices in 2012.

But this isn’t deterring those like John Husing, the chief economist for the Inland Empire Economic Partnership in San Bernardino, from promoting the notion of using eminent domain to acquire underwater mortgages and re-sell them to hedge funds.

Use of eminent domain to force loan write downs is the apparent brain child of Cornell University Professor of Law Robert C. Hockett in his June 2012 paper, “It Takes a Village: Municipal Condemnation Proceedings and Public/Private Partnerships for Mortgage Loan Modification, Preservation and Local Economic Recovery”.

Investopedia.com defines an underwater mortgage as “a home purchase loan with a high balance owed than the free market value of the home” on the open market. Homeowners with underwater mortgages typically cannot resell their homes unless they can come up with the cash to pay the loss off.

The median single-family home price in San Bernardino County is $158,500, as of May 2012.  The median home price in San Bernardino-Riverside Counties as of 2007 was $343,250. This reflects a 53.8 percent decline in value from the peak of the Housing Bubble.

Steven Gluckstern of Mortgage Resolution Partners, a private hedge fund proposing to batch the mortgages and re-sell them at a discount, says that roughly $1 billion would need to be financed to initiate eminent domain proceedings on 5,000 underwater mortgages.  The homes themselves would not be condemned.  That would reflect roughly $200,000 per home in loan write down needed.

Consider a home with, say, $315,000 loan balance as of 2012 — 50 percent its original value. In that case, a 60 to 70 percent loan discount would be indicated to provide a third-party investor a 10 to 20 percent profit. But this would result in a sale at less than the median home value of $158,500 today. It is not clear if homeowners would lose their rights to any future appreciation in their home as part of this deal.  If so, perhaps the entire property would need to be condemned as well.

A Redevelopment Agency for Over-Indebted Homes

The proposal to acquire underwater mortgages comes from Mortgage Resolution Partners, a San Francisco based group of venture capitalists. Mortgage Resolution Partners is led by CEO Graham Williams, who created Bank of America’s “award winning” Neighborhood Advantage low-income housing initiative.  Bank of America’s Neighborhood Advantage Program was essentially a “zero down” sub-prime loan program.

Reportedly, 150,000 homeowners have underwater mortgages in San Bernardino County.  About 20 percent of those mortgages — or 30,000 loans — are held in private mortgage-backed securities that could be acquired by eminent domain.  The eminent domain process would be funded privately. The re-selling of mortgages to hedge funds would be handled by private venture capitalists for a profit. But the county would hold the mortgages in a public/private joint powers agency.  Call it a “redevelopment agency for over-indebted homes.”

Eminent domain legal expert Gideon Kanner believes that eminent domain law is so broad in California that it could be stretched to allow the acquisition of underwater mortgages and still meet the legally required “public benefit” test.

Technically speaking, however, it is likely that a city could only legally condemn that portion of a mortgage that was “underwater” and not the whole loan. It would be unlikely that a “public benefit” could be justified for taking the portion of the loan that is not “underwater.”  This would be what is called a “partial taking” or “fractional interest taking.”  How that could be determined on 5,000 to 30,000 mortgages could be a logistic nightmare.

A ‘Lousy Idea’

But Kanner stated on his blog that this is a “lousy idea for a number of policy reasons”:

First, the county as condemnor would have to come up with the money to acquire the mortgages by a public-private partnership that would issue some sort of mortgage revenue bond.  Public-private partnership is a code word for what used to be called “redevelopment” in California until Gov. Jerry Brown and the state Legislature shut down redevelopment agencies in 2011.

Second, the standard for “just compensation” in eminent domain is Fair Market Value.  But banks and private mortgage lenders hold mortgages on their books for their higher “book value.”  The open market value of the homes serving as collateral for an underwater mortgage would be lower than the “book value” of the loans.

But you can’t use eminent domain law to acquire a home, or a mortgage, “on the cheap” at less than the balance owed on the loan.  The concept of just compensation is to “make the property owner whole.”  So eminent domain probably can only be used to force banks to sell their loans at full book value, not at a discounted value.

Nonetheless, mortgage loans would have to be sold at a discount in order for private investors to make a profit.  Thus, the county would have to be willing to buy loans at their face value and sell them for much less. The spread is called a discount, which reflects the margin of profit to the seller of the loans.

Steve Body, a commercial real estate appraiser and securities trader in Eagle Rock, California, stated that the expected discount on underwater mortgages would probably not be as low as the typical 10 to 12 percent in bankruptcy court.  He said it would also not be as high as 50 percent found in highly distressed assets.  That is because most homeowners with underwater mortgages are making their loan payments.  He believed a discount in the 20 to 40 percent range would be typical.  But Body stated that, paradoxically, if a public entity buys and guarantees payment on the loans, there would be less risk and thus less of a discount or profit for investors.

Both Body and Kanner mentioned that there would be another big impediment for banks selling their loans even at their full book value. Coercing banks to sell a portion of their loan portfolio might drop bank reserves to less than the minimum reserve of stress tests required by bank regulators.

Body cautioned that another impediment for banks could be what is called “fractional interest banking,” where banks loan out the same money, say, seven or eight times.  Could banks demand just compensation for the lost opportunity cost of a multiple of the book value of the loans? What bank would agree to a voluntary condemnation of their underwater mortgages and forego such profits?

Kanner warned of a repeat of the Savings and Loan Crisis of the 1980’s and early 1990s, when savings and loan banks had to sell their junk bonds at fire-sale prices by order of the federal government.  This resulted in the collapse of several savings and loan banks. 

Hazard of Non-Payments

But Kanner warns of even more “calamitous consequences.” There is hazard in reducing the loan balances on mortgages if borrowers are provided an incentive to stop making payments on their mortgages, hoping to get bailed out by the government.

And then there is the potential problem of the mass flight of property owners dumping their homes once their loans are reduced — to get out of California or take better jobs elsewhere.  Think of government-reduced mortgages as a one-way ticket out of San Bernardino.

And then there would be the prospective slippery slope problem that, if this were implemented in San Bernardino, where would it stop?  Other distressed counties would be politically pressured to reduce all the underwater mortgages in their jurisdictions, too.  A house of cards could result in the entire housing market collapsing.

And loans would likely be re-sold into a mortgage market at the same time as the federal government is dumping foreclosed homes on the market.

The proposal to use eminent domain to reduce over-indebted homes is filled with multiple unintended negative consequences.  But these consequences are foreseeable and thus potentially avoidable. Desperate cities should beware of hedge funds offering bailouts.