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Friday, July 13, 2012

Eminent Domain Will Destroy Housing

I am hearing that San Bernardino County in southern California is considering using its eminent domain powers in furtherance of "the public good" to seize home mortgages and reduce the principal amount on them in order to keep homeowners in their homes.  This is a dangerous idea that will destroy the housing market and reduce the value of all residential real estate.  Even worse, it will have a pernicious, discriminatory effect upon minorities and working-class areas.

When the state comes in and seizes an asset like a mortgage, it forces a renegotiation of all terms on the bank or investor group holding the mortgage note.  The noteholder will suffer an immediate and substantial loss.  Although the mortgage may be decades from maturity, the mortgage itself will lose value because the aggregate principal -- plus the aggregate interest payable -- will be cut.


Does this help the homeowner? Not necessarily.  With the exception of jumbo mortgages, it is the rare conforming mortgage where a principal reduction will result in a substantial cut in the homeowner's monthly payment of more than a few hundred dollars.  Most defaulting homeowners are unable to afford to stay in their homes, at any price.  Saving a few hundred dollars through either a principal reduction or mortgage modification (dropping the interest rate) is always unlikely to keep troubled homeowners in those homes. The reasons those homeowners are distressed are often severe: job loss, permanent disability or major medical problem, and regional economic problems. Reduced affordability cannot be cured by a mortgage modification.  Data does show that many homeowners receiving a mortgage modification do default again.  

Many distressed homeowners simply cannot afford to stay in those homes -- at any monthly payment. Modifying their mortgages or mandating a principal reduction (whether through eminent domain or another device) won't help them.  But it will hammer the banks and investors.  And that's what will lead to ruin in the housing market. 

Our real estate market depends on credit. Lenders will not -- repeat, will not -- make loans of any type if our regulatory environment starts encouraging cities and states to seize and unilaterally modify mortgage loans or other types of loans.  A lender, whose mission is to make money, will not make a loan when it cannot account for this substantial risk of loss.  Using eminent domain to mandate principal reduction will force banks and investors in mortgage backed securities to take losses.  When these parties are forced to take losses, they will be extremely scared to make further loans unless they can account for the risk of loss and the future risk of unilateral government renegotiation of the loan terms.  That will be virtually impossible, at least not without skyrocketing interest rates in at least the teens.

Eminent domain will induce banks to engage in a new form of redlining.  Eminent domain powers will cause banks to refuse to grant mortgages -- except perhaps on terms radically different from what we've been used to all these years and except on properties where the real estate market is the "healthiest."  The weakest real estate markets, the ones with the most defaults, delinquencies and foreclosures, will naturally be the areas where eminent domain will likely be used the most.  The weaker the market, the harder it will be to get a mortgage.  The only buyers in the weak markets will be paying all cash, and when this happens, housing prices will collapse as buyer demand evaporates.  Thus an irreversible price death spiral will begin.

Are you concerned about low-income, working class and minority homeowners?  These are the homeowners most likely to be "first generation" homeowners and to live in areas with other troubled homeowners.  The disastrous impacts I predict here will be strongest in these areas.  Minority homeowners will be at the highest risk of having their property values plunge as banks refuse to make mortgages in their towns.  

Eminent domain will create a class of toxic housing.  Undesirable.  Untouchable.  Unsaleable at any price.

The larger issue of having governments renegotiate the terms of loans between private parties is also relevant here.  Nothing will cause a credit freeze quicker than government power to seize assets and force loan renegotiations.  Housing will be destroyed, as will most finance and then, most economic activity.

The downside to this use of eminent domain is catastrophic. This risk is not worth it, not when the "help" to troubled homeowners will be temporary and minor.

Eric Dixon is a New York attorney, political strategist and radio talk show host.  Mr. Dixon is also a director of the Financial Policy Council.   

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