Cities Seizing Mortgages Is a Shortsighted Idea

A number of cities around the country are openly considering using their power of eminent domain to seize mortgages instead of property. The idea is for the city to step into situations where homeowners are deeply underwater in their houses, owing much more than the houses are now worth. The city would pay the fair market price to the mortgage holder which would be less than the current value of the house because of the high probability that such borrowers will default.

Then the city would arrange a new mortgage for the homeowners that would give them a little equity in the house, yield a profit to the city, and produce a profit for the holder of the new mortgage. It sounds like a win-win-win.

Unfortunately, such a policy is very short-sighted, will not produce economic growth in the aggregate, and will have the longer-run effect of increasing mortgage interest rates.
Homeowners who receive a new, modified mortgage under such a program certainly benefit as they get substantial debt relief. Also, because they would no longer be underwater, they could sell their home more easily which could help the real estate market continue its recovery. These are the good parts of this policy.

Cities think it will spur local economic growth, and they may be right depending on the location of the mortgage holder whose mortgage is seized. Any reduction in homeowner debt is offset by a loss to the current mortgage holders. Net, across the entire economy, there is no gain. However, city officials are elected to represent and serve their citizens. Thus, if their city is helped while people somewhere else lose (assumably, big banks or investors in a far off financial center), that could be a good policy from the city's point of view. But nationally, the impact is different. In the big picture, this policy is a wash as it is just another wealth redistribution scheme.

The big impact of such policies will be in the long run. Investors who hold the mortgages are very concerned about such eminent domain seizures. Cities that implement such policies are likely to see some lenders drop out of their market and mortgage interest rates nationwide are likely to rise due to this new risk in the mortgage market.
A mortgage is a contract between a lender and a borrower. The lender has a legal right to interest and principal payments and foreclosure rights if they do not receive the agreed upon payments on schedule. Lenders face nonpayment risk, collateral risk (that the house may not cover the balance owed upon foreclosure), inflation risk, and interest rate risk. All these risks factor into the interest rate that mortgage lenders offer to borrowers. Lenders mitigate property damage risk and title risk by requiring insurance to protect against them.

Now, on top of those risks, some politicians eager to pander to voters and perhaps help revitalize neighborhoods want to add a new risk: government seizure. While the city would have to pay the lender a fair value for the mortgage, "fair" is subjective and cities have the upper hand in eminent domain proceedings. Lenders may well feel that the fair price paid for their mortgages is less than they might have collected over time or less than they could have sold the mortgages for on the secondary market. If so, lenders will see this as a new risk, the risk of having value seized from them by local governments.

Adding a new risk to the mortgage lending industry means that lenders must be compensated for taking that extra risk. That compensation will come in either higher closing costs or higher interest rates. Whichever is chosen, borrowers will end up paying more for their mortgages.

Because lenders have to anticipate future risks, they have to protect themselves against the possibility that over the potential thirty years of the mortgage a local government could begin such a program. That means costs won't just rise in locations that adopt such policies, but everywhere.

If a few select locations decide to adopt a policy of seizing mortgages through eminent domain a small number of underwater borrowers will gain in the short run, through significant debt relief. The cost of achieving those local gains could be very high. Borrowers in the entire country will face higher interest rates as lenders internalize the cost of this new risk to their business.

Instead of a bailout of at-risk mortgage borrowers in which taxpayers bear the cost, such a policy is really a bailout of certain at-risk mortgage borrowers with the cost borne by all future mortgage borrowers.

Relief would be limited to borrowers in locations which adopt such policies, but costs would be transferred to people everywhere. The local benefits and diffuse costs provide an encouragement to cities to adopt such a policy quickly once a pioneer shows it can be done. It also means lenders will perceive this new risk as a large one, justifying large increases in the cost of a mortgage.

Lenders are likely to fight in court against such a policy when it is first tried. If lenders win a few early court cases, cities will move on to other ideas and forget about using eminent domain powers in this new way. If a city manages to obtain legal approval for such a program, such programs could spread rapidly as other cities' citizens demand their politicians help them the way they see their neighbors being helped.

In that case borrowers everywhere, both responsible and irresponsible, will face higher costs to obtain a mortgage. Using eminent domain to provide debt relief may seem like a creative neighborhood revitalization program but it is really just another government bailout. The only real difference is that the cost of this bailout is hidden in the price of everybody's mortgages and will continue forever, even after such programs have ended.