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TheStreet Open House

Eminent Domain Mortgage Battle Is a Lose-Lose Situation

Stocks in this article: XLFXHBIYR

Richmond proposes buying the mortgage at a discount to current home values, a measure of compensation likely to be contested by investors.

As reported by The New York Times, the plan works something like this:"In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default. Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program."

The homeowner goes from being underwater to actually having equity of $10,000. The profit of $30,000 goes to a flat fee to Mortgage Resolution Partners and to investors who funded the purchase of the mortgage.

Investors are likely to dispute the compensation price in court. They may demand that they be rewarded on the present value of future cash flows of the mortgage and not on the value of the underlying home.

"Courts tend to overcompensate properties taken under eminent domain as a general rule," said Reiss. "The proponents of this rule may be underestimating how these mortgages will be valued."

If the mortgages are valued higher, it may change the economics for the proposal. Buying a mortgage for higher than the property value would mean that borrowers are still underwater, defeating the purpose of the proposal.

"This is going to be very expensive for municipalities if banks fight," said Duggan.

Besides the legal complications, other cities may still have cause for pause when exploring this controversial strategy.

Investors have warned that the cost of credit could go up in municipalities such as Richmond that use eminent domain to seize mortgages.

Proponents have dismissed this, saying refusal to lend to these communities is tantamount to redlining or discrimination against minority communities.

However, investors frequently do factor in local laws governing foreclosure and other aspects when deciding to buy mortgages. If the secondary market demand for mortgages in an area shrinks, it could reduce the availability of credit.

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