Can local governments condemn crappy mortgages?

Tad Friend has an article (abstract only, sorry) in the February 4th issue of the New Yorker (which should be hitting my mailbox, oh, around February 12th) about a company’s creative plan for helping communities hit hardest by the mortgage crisis. In these places, a large number of homeowners are underwater, meaning they owe more on their mortgages than their homes are worth.

This has a toxic effect. People start looking at their homes and communities not as things they are connected to, but things they’d love to get away from, if only they could. The rational thing for many of theses folks is to simply walk away from their homes and let their mortgages default. When other struggling homeowners see some people walking away, they think, rightly, “Why am I making my payments? I should default too.”

Inflated mortgage principals eat these communities up from the inside out.  

The company’s plan addresses the problems of individual homeowners, but more importantly, it addresses the problems of these communities, namely that its underlying real estate is worth much less than what’s owed on it.

According to Friend, of all of the ways to provide mortgage relief, nothing works as well as fixing the mortgage valuation. That is, to rewrite the mortgage so that the principal reflects what the house is worth now, rather than its worth at the height of the housing bubble, when so much of the sales price was jacked up by speculative froth.

This has been shown to work better than simply lowering the mortgage interest rate or lengthening the term. Once homeowners feel they have real equity in a property, they feel a greater attachment to it, and are much less likely to default.

The problem with doing this, even on a small scale, is that the mortgages for the homes that are most underwater are nearly always the ones that are hardest to fix. Why? Because they were sub-prime mortgages created for the express purpose of being sold as market securities. They were mixed up, sliced up and sold. In order to change these underlying mortgages, you have to get the permission of the lenders, but in this case the lenders are an untold number of individual and institutional investors. There’s no there there.

Others have looked at this and come up with a very different idea for how to fix these mortgages. They claim that where the deed for a property is not tied to the underlying promissory note—and in the old days, they were literally tied, with a ribbon—then the mortgage is null and void. What the entrepreneur in Friend’s article is proposing seems tame by comparison.

So what is the proposal? In a nutshell:

  • The local city or county government condemns mortgages it decides are toxic and takes them over by force of eminent domain. 
  • They pay the investors holding the securities 80% of the homes’ current value and say, see ya later, pal. Just be glad you got something, because you could’ve easily gotten nothing. 
  • They give the homeowner a new mortgage with a principal just a bit under the home’s market value. Instantly, the homeowner has equity, and a mortgage that is much easier to pay down. 
  • The difference between what the old investors got and the value of the new mortgage is split by the local government, the new mortgage investors, and the company brokering the deal. (Yes, it’s a profit making concept. This is, after all, America.)

Brilliant. Win-win-win-win-win-win.

But noooooo. Banks and Wall Street HATE this solution. They say it “bails out” homeowners who took out dumb loans without forcing them to pay the consequences.

Once you let the breathtaking, bald-faced hypocrisy of that sink in, give Friend’s article a read.