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How Eminent Domain Mortgage Plans Signal a Failure in Housing Policy

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Proposals for municipalities to use eminent domain are as dysfunctional as the housing markets they are trying to address. But the intention is good, and you have to give eminent domain's proponents considerable points for creativity.

Necessity, as they say, is the mother of invention. Local officials are fed up with both a lack of national leadership and servicers either unwilling or unable to quickly rescue underwater borrowers. With nowhere else to turn, these officials (and companies influencing them) are finding creative, if controversial, solutions to the housing mess. One of them, eminent domain, is a well-meaning bid to help individual homeowners, but one that also would raise borrower credit costs and undermine efforts to inject private capital back into mortgage markets. And it's the virtual lack of private capital to support the secondary market in mortgages that has impeded a meaningful housing recovery – for all.

Mortgage securities, unlike standard fixed-income instruments such as Treasury bonds, include two very important, financially free options to the borrower: default and prepayment. Investors price a mortgage security in part based on the level of prepayments and defaults they expect over time. When prepayments accelerate (usually due to refinancings but also as part of loan modifications) beyond the expectations of investor pricing models, it results in a lower value for the security, as investors no longer enjoy the cash flows from the original higher coupon levels. Thus pricing a mortgage-backed security requires valuing defaults and prepayments in conjunction with the cash flows of a default-free bond.

Estimating how many loans will prepay in a mortgage pool is inherently complex even when mortgage markets are responding normally. But continued tinkering with federally and legally induced prepayments, such as under the various loan modification and attorneys general settlement programs, makes estimating this option's value even more challenging. An eminent domain plan also artificially induces prepayment, leading to the prospect of lower security values for an investor in such securities. Higher mortgage rates to borrowers reflect what investors are willing to pay for these securities under this greater prepayment uncertainty.

What is worse is that the eminent domain proposals are not applicable across the entire market, but are focused only on private-label securities. This unevenness in the application of eminent domain across the mortgage market threatens to seal the fate of any comeback of private capital, and may in fact limit the role of government-sponsored mortgages, based on the FHFA's response to eminent domain proposals last week. Compound that with the fact that individual local governments can effectively choose their approach to implementing eminent domain, and you have a balkanization of mortgage policy that is appealing in this neighborhood or that neighborhood but uncomfortably un-American in its resemblance to legislative fiat. 

Still, you can't really blame local jurisdictions for trying. Eminent domain is a natural reaction, born out of desperation and frustration with the federal level's complete abdication of leadership in housing. There is no comprehensive housing finance strategy that provides a clear roadmap for how and when various reforms will be implemented. There is no comprehensive public-private partnership to reform housing finance for future borrowers, nothing that establishes creative financing structures to attack each problem area in housing, from current and underwater borrowers to those in default. The solutions cannot continue to be piecemeal as they have been (and eminent domain is nothing if not piecemeal). Coordination among key policymakers has been woefully lacking since the crisis, so it should not be surprising to see state attorneys general and local leaders talking about eminent domain. But with housing a critical component in the rejuvenation of a faltering economy, abdicating policy to state and local governments is clearly not the answer.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.

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