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» VISIT US ONLINE @ DSNEWS.COM POINT—COUNTERPOINT I n San Bernardino County, California, officials are considering using eminent domain to seize underwater mortgages. The proposal would allow the county and participating municipalities to take possession of mortgages in a negative equity position at the cost of fair market value, then refinance the loans with terms reflecting the current value of the underlying homes. With estimates stating more than half of the mortgages in San Bernardino County are underwater, clearly, a solution is needed. Opponents of the eminent domain proposal, however, see the solution as causing more losses than gains, especially for investors. Proponents of the idea see it as a win-win, minimizing losses for investors since negative equity increases the likelihood of default. DS News asked the Cornell law professor who conceived the eminent domain plan and the man who once oversaw the credit portfolio of the nation's largest mortgage investor, Fannie Mae, to share their perspectives on the San Bernardino proposal. According to Robert Hockett: Much interest has emerged in the use of eminent domain authority to reboot the nation's still slumping mortgage markets. But just as the inevitable queries and discussions have proliferated, so have some misconceptions. Chief among these is the belief that some constituency must "lose." This belief that eminent domain proceedings always represent a "zero sum game" is simply false. Everyone can win under the eminent domain solution if the stakeholders will not squander resources on pointless litigation, lobbying, or strong-arming efforts over the spoils. Key to understanding why the eminent domain solution can benefit literally everyone is the notion of a needlessly wasteful collective action problem. A collective action problem is a situation in which everyone experiences avoidable loss even when everyone acts rationally because even rational actions sometimes can aggregate into dysfunctional outcomes when not orchestrated through some coordinating instrumentality like a government. Bubbles and busts are classic cases in point. The nation's ongoing mortgage troubles are rooted in problems of this variety. To see this, note first that where underwater mortgage loans are held by individual banking institutions not faced with collective action challenges, principal is commonly written down to where borrowers have equity in their homes and can realistically pay off their debts. Why? Because banks know that underwater loans default and foreclose in high numbers, which lowers what economists call the "expected values" (EVs) of these loans. In order to raise the EVs, and with them the values of their portfolios, banks routinely write down principal on their portfolio loans. Now consider another, far more significant class of underwater loans: the securitized loans held by legal trusts in which millions of individuals hold bond interests. These loans, which now represent the great bulk of still underwater mortgage loans, are overwhelmingly not written down. Why? Because the millions of bondholders in securitized mortgage loan pools cannot find one another to write down or sell off pooled mortgage loans. And the contracts under which these pools were formed—written during the bubble years when few anticipated a real estate crash—typically prevent servicers from doing this for the investors. Hence they prevent markets from repricing securitized underwater loans in the way markets reprice portfolio loans. Enter the eminent domain solution, which sidesteps these market-paralyzing contracts so markets can once again do what they generally do best: recoup value. This recouped value can benefit everyone. Current first lienholders will get fair market value for their presently unmarketable assets. Investors in the written-down loans, who will include current first lienholders themselves, get a modest return on the funds they lend to pay firsts. Homeowners get positive home equity and stay in their homes. Neighbors' homes stop losing value. Municipalities recover revenue bases. Even second lienholders are paid sweeteners out of the value recouped by the writedowns, while in foreclosure they'd get nothing. Everyone can win under the eminent domain solution because it recoups presently lost value and distributes it equitably. Let's hope more will act in the interest of all and support cities in their effort to clear our clogged mortgage markets and restore local and national prosperity to all Americans. According to Edward Pinto: This plan faces serious legal challenges, and its implementation is fraught with problems. It is not the free lunch as promoted by its supporters. First, with billions of dollars at stake, the plan's legality will be challenged by bond holders, resulting in a multi-year legal battle. We are already six years into the crisis. This will further delay the clearing of markets. The question is whether using the power of condemnation serves a public use (as required by law) or a private use. The plan by Mortgage Resolution Partners has investors bearing all losses. However, Mortgage Resolution Partners and its investors stand to profit handsomely, raising questions about whether it is for a public use. Second, it is bad policy. It strikes at the heart of the contractual relationship underpinning the securitization of mortgages and the relationship between lender and borrower. As with many anti-investor actions, this will materially impact investors' willingness to buy private mortgagebacked securities and to risk the capital needed to support these securities. The result would be higher rates and further entrenchment of the "Government Mortgage Complex," which ultimately leaves taxpayers holding the risk. This approach would be on top of other antiinvestor actions, one being the exclusion of private investors from the states' attorneys general national mortgage settlement, which provides for principal reductions paid from investor funds. Since this plan would be implemented locally, investors could not invest in securities from these areas, raising rates for borrowers in the affected localities. This is particularly relevant to San Bernardino, which suffered from two huge real estate busts since 1991 that the market will be hard pressed to ignore: a decline of 20 percent over 1991 to 1997 and a decline of nearly 50 percent over 2006 to the present. Third, even if found to be a legal use of eminent domain, the economic feasibility of the plan is questionable. Any seizure must be based on paying fair market value—again an issue that will be litigated long and hard. The plan's approach to determining fair market value appears to differ markedly from the likely fair value of the loans targeted. Of central concern is that the plan targets the most valuable loans from an investor's perspective: those that are making payments every month, many of which will continue paying for many years or will be paid off in full even though they are underwater today. The plan's economic viability is based on an assumption that each loan is worth about 80–85 percent of the current value of the home. Yet each of the targeted loans is performing today.  Zillow reports that while 53 percent of the mortgages in San Bernardino County are underwater, about 80 percent of the underwater mortgages are not seriously delinquent. The non-delinquent mortgages targeted by Mortgage Resolution Partners are worth more to investors than they propose to pay. Finally, if the value paid is not fair, there could be additional losses for those investors with the less risky slices of the securities, such as Fannie Mae and Freddie Mac. This pits one class of investor against another, adding to the expected legal battles. 71

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