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California Gold Rush? Righting Underwater Mortgages

A public condemnation of San Bernardino’s underwater mortgages could convincingly model the benefits of principal write-downs.

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Ever since the housing bubble collapsed, the federal government has refused to take major initiatives to help underwater homeowners. As a result, we are likely to see close to 1 million foreclosures both this year and next, with the numbers only gradually slipping back to normal levels by the end of the decade.

The inaction cannot be attributed to a lack of opportunity. At the time the Troubled Asset Relief Program (TARP) bailout was being debated in the fall of 2008, many progressive members of Congress wanted to have a provision that would at least temporarily alter bankruptcy law to allow judges to rewrite the terms of a mortgage.

Under current law, home mortgages are treated differently than any other type of debt. Bankruptcy judges are prohibited from altering the terms of a mortgage in anyway. If a homeowner cannot meet the terms of the mortgage, they lose the house. Congress could have allowed bankruptcy judges to rewrite mortgages that were written during the housing bubble frenzy, but it backed away from this opportunity.

Similarly, Congress could have temporarily changed the rules on foreclosure to allow foreclosed homeowners to stay in their homes for a substantial period of time (for example, five years) as renters paying the market rent. This would have assured underwater homeowners substantial housing security.

Either of these measures would have radically altered the relationship between investors and homeowners. They would have given homeowners a serious weapon that they could have used to threaten lenders and hopefully persuade them to agree to modify underwater mortgages. However, since Congress did not take any action to shore up the position of homeowners, we are still sitting here with more than 11 million homeowners underwater, five years after house prices began their plunge.

This failure at the national level provides the backdrop for a plan by a group of investors, Mortgage Resolution Partners (MRP), to try to get through some of the morass in the housing market. MRP has been working with public officials in San Bernardino, California, to arrange to use the government’s power of eminent domain to condemn underwater mortgages.

As background, San Bernardino is ground zero in the housing bubble. Prices doubled or even tripled in the bubble years. They plunged when the bubble burst, with prices now often less than half of their 2006 peaks. Half of the mortgages in the county are underwater.

This collapse has not only destroyed the life savings of hundreds of thousands of homeowners, it also has wrecked the economy of the region. In this context, the prospect of using the power to condemn property to bring many underwater homeowners back above water must sound very appealing.

MRP’s plan is to have the county condemn underwater mortgages in private mortgage pools. The logic is that these underwater mortgages are causing serious harm to the community. When people are seriously underwater in their homes, they are likely to lack both the means and the incentive to properly maintain their homes. Of course, the monthly payment on a mortgage that might exceed the current value of a home by 50 percent or more (and carry a high interest rate) is a huge drain on the purchasing power of homeowners.

The case for focusing on mortgages in private mortgage pools is that it is generally quite difficult to sell these mortgages out of the pool. This means that even if, in principle, it might be advantageous for both the investors and the homeowners to have pools sell underwater mortgages to third parties like MRP who would rewrite the terms, the rules of the mortgage pools makes it unlikely that the mortgage will be sold.

This is exactly the sort of situation where public action like condemnation is appropriate. The public action allows for a solution that can benefit all the parties but is obstructed by bureaucratic rules that were written to cover a different set of circumstances. (It is important to remember that investors can contest in court the compensation they are provided for condemned mortgages to ensure that they get fair market value.)

It is difficult to see a good argument against this approach. Some have claimed that this sort of tactic will cause lenders to be more reluctant to lend in the future. If the point is that lenders may have second thoughts the next time house prices go into a bubble, then we should certainly hope that condemnation will have this effect.

Others have been critical because MRP is a private company that is doing this to make a profit. I’ve met with several of the top people at MRP; they certainly don’t hide the fact that they expect to make money on this deal. But that hardly seems a reason for nixing the plan. There are very few instances where there has been a public condemnation in which private firms didn’t stand to profit in some way.

MRP’s plan is not going to rescue the country’s underwater homeowners. At best, it will directly help the limited segment of this group whose mortgages are in private-label securities. However, it may serve as an example of the benefits of principal write-downs, and perhaps prod Fannie and Freddie, as well as the banks, to be more willing to go this route.

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