An Off-the-Wall Plan to Save Homeowners (and Make Some Investors Rich)

In California, a venture capital fund wants to help local governments seize mortgages from banks and give borrowers a break. Who cares if investors would make a killing? The housing market might get healthy. 

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It is distinctly possible that some small cities in California and a venture capital fund are hatching a plan that could fix our sick housing market and maybe start healing the economy.

More than five years after the real estate bubble began to burst, it's sometimes easy to lose sight of the fact that real estate is still the source of America's chief economic affliction. About a fifth of all U.S. mortgages are currently underwater, meaning the borrowers owe more to the bank than their homes are worth, according to CoreLogic's widely cited estimate. That's 11.1 million households who are stuck paying off debt on a bad investment they've been trapped in instead of spending on trips to the mall, a new car, or a vacation.

Washington has the power to fix some of this mess, but it's not. Fannie Mae and Freddie Mac could give millions of homeowners a break by writing down the principal on their mortgages. So far, though, their government regulators have said no to the idea, much to the chagrin of House Democrats.

Short of a massive federal effort that may never materialize, a couple of municipalities in California may have found the next best option. As the Wall Street Journal reports today, San Bernardino County along with the cities of Ontario and Fontana are considering using their power of eminent domain, which allows state and local governments to claim private property for public use, to do a backdoor principal reduction program.

The idea is being pitched by San Francisco venture-capital firm Mortgage Resolution Partners as a cooperative public-private effort. Here's the WSJ's explanation of of how it would work:

For a home with an existing $300,000 mortgage that now has a market value of $150,000, Mortgage Resolution Partners might argue the loan is worth only $120,000. If a judge agreed, the program's private financiers would fund the city's seizure of the loan, paying the current loan investors that reduced amount. Then, they could offer to help the homeowner refinance into a new $145,000 30-year mortgage backed by the Federal Housing Administration, which has a program allowing borrowers to have as little as 2.25% in equity. That would leave $25,000 in profit, minus the origination costs, to be divided between the city, Mortgage Resolution Partners and its investors.

According to the paper, Mortgage Resolution has told investors that it would start with a $5 billion effort in California, then expand to a $500 billion program nationwide.

The plan isn't a sure thing. Banks would almost certainly challenge the use of eminent domain in court, and cities would have to prove that preserving their tax rolls and preventing the urban blight associated with foreclosures was legitimately in the public interest (though, as the paper notes, the Supreme Court has traditionally given states wide latitude on these issues). There's also the chance that, as they're now warning, banks would get jittery about lending in places where local governments were seizing mortgages, which might discourage some cities from participating.

Those concerns aside, this plan could be a game-changer for the housing market if it goes national. Even if FHFA does relent and starts reducing principal on its own, Fannie and Freddie only back about 3 million underwater mortgages. That leaves millions of other households stuck under the weight of their debt that could be helped by the sort of program these counties are considering. Even more importantly, it would let cities move forward on principal reductions without resolving a seemingly intractable federal battle.

There is something a tad bit unseemly about letting a private investment fund profit off of eminent domain, as Mortgage Resolution Partners would in this case. But if you care about getting homeowners' finances back in shape and righting the economy, the ends here justify the means. Hopefully this experiment takes off.