Any attempt by municipalities to use their powers of eminent domain to seize and purchase underwater loans out of private-label MBS will face “serious legal challenges” that will take years to litigate, according to a critic of government-backed mortgage programs.

“Since billions of dollars are at stake, the legality of this approach will be challenged by bond holders,” said Edward Pinto, a resident fellow at the America Enterprise Institute.

San Bernardino County's board of supervisors voted to form a joint powers authority with area cities to explore using eminent domain to seize mortgages on underwater homes and restructure the loans to show current home values. Fontana, CA and Ontario, CA joined the joint powers authority

These California municipalities' plan is to condemn underwater mortgages and purchase them at fair market value so the residents can be refinanced. The net effect will be a principal reduction for the borrowers. For the cities, it will presumably prevent foreclosures, further declines in properties values and blight.

Pinto says the seizing of mortgages is “more like grand theft mortgage than a silver bullet.”

He points out that the eminent domain approach targets performing loans—the bondholders’ most valuable loans—which amounts to “cherry picking.” And the plan assumes none of the loans will be paid off in full.

“The plan also appears to ignore the high transaction costs associated with eminent domain and mortgage lending—further diminishing its viability,” according to the AEI resident fellow.

If the courts uphold the use of eminent domain in taking mortgages, it would open the door for the cities to purchase the loans at “fair value.” But the valuation of those loans could be challenged by the bondholders, Pinto said. “Therefore, this issue will also be litigated long and hard.”

In other commentary on the subject, Fitch Ratings said today that the potential use of eminent domain by California communities can negatively impact private-label RMBS performance.

The rating agency said that proposals that target borrowers who are current on their existing mortgage obligations are particularly detrimental. Also damaging would be those that are aimed at borrowers who are still performing as expected except for the ability to restructure their mortgage through the eminent domain approach.

According to Fitch, considering that eminent domain offers a mechanism for local, county, or state governments to take mortgages at their market values, the loans' holders can experience losses if these communities proceed with this move, Fitch said. 

San Bernardino is the largest county in terms of area in the country so the impact can be broad. In these three areas of California altogether, roughly $14 billion worth of non-agency mortgages and over 46,000 of the loans have mark-to-market combined loan-to-value (MTM CLTV) ratios of more than 100%, the rating agency reported. Roughly half of those underwater loans are current. One proposal is aimed at only those current and delinquent mortgages, not those in foreclosure.

If the use of eminent domain were to actually happen, it can be adopted in other regions and have a considerable impact on the RMBS sector. In California alone, there are more than 590,000 non-agency borrowers with MTM CLTVs of over 100%, for an aggregate $241 billion in debt.

Across the entire country, the figure rises further to 2.2 million borrowers and approximately $589 billion underwater. In addition to pushing forward losses on performing loans, such a program can also have other unintended consequences such as negatively affecting mortgage interest rates and credit availability in affected areas. The implementation of this program can also further weigh on private investor confidence and their future appetite for private-label RMBS.   

Fitch analysts think that the possible legal challenges to invoking eminent domain might make movement toward it slow and difficult. They will continue to monitor this situation and offer further comment if they learn of any meaningful activity, the rating agency stated.

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