On Thursday, September 6, Berkeley Law Adjunct Professor Bill Falik gave a presentation on his pioneering efforts to stabilize the mortgage market and prevent future foreclosures through the government’s use of eminent domain.
Having expertise in real estate, land use and development, Bill Falik started thinking about ways to stop the deterioration of the housing market after one of his housing developments in Roseville, CA was hit by a wave of foreclosures. “A group of us got together and started thinking about creative approaches to resolving the mortgage crisis and stopping foreclosures”, says Falik about the founding of Mortgage Resolution Partners (MRP), an organization seeking to implement this innovative strategy as a way to keep homeowners in their homes.
The unfortunate effect of the sharp drop in real estate prices over the past five years was that many homeowners found themselves in a situation where they owed more on their mortgage than their home was worth. These mortgages, commonly referred to as “underwater mortgages,” present a serious threat to the stability of the market due to their prevalence and high likelihood of default. In fact, Falik estimates that “there are currently over 12 million underwater mortgages in the United States” (or even as many as 16 million, according to Zillow), comprising around one third of all borrowers.
When borrowers hold negative equity, they are more likely to default in the face of financial setbacks because they do not have the option of selling their home and relocating to more affordable housing. In addition, foreclosures result in abandoned properties and a decrease in property values for the surrounding area.
These problems have been alleviated to some extent by low interest rates that allow qualifying homeowners to refinance their mortgages and decrease their monthly payments. Government-backed mortgages (Fannie Mae, Freddie Mac, Ginnie Mae) are regulated by the FHA and refinanced through specified protocols. Recently, the FHA lifted the limit on how much negative equity a borrower can have in order to qualify for refinancing.
However, the same doesn’t hold true for private-label mortgage-backed securities (PLS), which are held by investors, banks and other financial institutions. These mortgages make up roughly 20-30% of the market and a disproportionally larger share of mortgages that are underwater. These mortgages have been “sliced and diced” in the securitization process and are controlled by very restrictive Pooling and Servicing Agreements administered by loan servicers, which make loan modifications of any sort extremely difficult. Because of this, many borrowers with underwater mortgages who are unable to make the payments have limited alternatives—either walk away or continue to make payments on mortgages that are significantly underwater and offer little prospect for getting above water.
Falik and MRP claim to have a viable alternative for these homeowners, which would allow them to stay in their homes and open up an opportunity to refinance their loan as well as reduce the principal. MRP argues that this can be achieved through local governments’ use of eminent domain to seize private-label underwater mortgages, which would then be restructured and ultimately sold to private investors. On one hand, the plan is appealing because there would be zero cost to taxpayers. On the other hand, lenders and investors would receive less than the principal of their original loans. MRP argues that doing so would constitute a legitimate use of eminent domain and unsurprisingly, private lenders claim that it would not.
The government can use the power of eminent domain only when the “taking” is in the public interest and just compensation is provided to the interest holder. Even though this power has been used mainly for acquisition of tangible real property, MRP points to a California Supreme Court decision concluding that eminent domain law authorizes the taking of intangible property. (City of Oakland v. Oakland Raiders (1982) 32 Cal. 3d 60, 64 [646 P.2d 835].) MRP also plans to rely on a California Supreme Court decision where the court has defined “public use” as “a use which concerns the whole community or promotes the general interest in its relation to any legitimate object of government.” (Bauer v. County of Ventura (1955) 45 Cal. 2d 276, 284 [289 P.2d 1].)
However, the jury question of what would constitute just compensation is much more controversial. MRP contends that the fair market value of an underwater mortgage is lower than the principal because statistically, those mortgages are disproportionately more likely to spiral into a costly process of default and ultimately foreclosure. Opponents of the plan, like the Securities Industry and Financial Markets Association (SIFMA) and the American Securitization Forum (both are trade groups that represent mortgage-holding trusts that stand to recognize a loss if the measure is passed) argue that “fair market value” should be based on the value of the loan owned by the trust, not the value of the property securing that loan. This view stems from the fact that most borrowers holding underwater mortgages are still current on their payments, thus allowing the issuer to represent the loan value as the principal rather than the underlying property market value.
Opposition to the plan has been powerful and persistent. For example, in a July 19 statement, SIFMA announced that mortgage loans given to homeowners in jurisdictions where governments have begun eminent domain proceedings would not be eligible for securities traded on the TBA market. Also, in a recent letter request, SIFMA has asked the Federal Housing Finance Agency, which governs Freddie Mac and Fannie Mae, to effectively redline any community using the power of eminent domain to acquire underwater mortgages. This has led Lt. Gov. Gavin Newsom to call for an investigation of Wall Street firms he accused of colluding “to restrain trade and to redline communities” in a formal letter last Monday.
While the heated debate regarding the legality of the plan is likely to continue, its ultimate future lies in the hands of local jurisdictions and the courts. Without doubt, the outcome will have a major impact, not only in terms of mortgages currently at issue but also as important guidance for addressing the mortgage crisis in distressed communities in California and across the country.