My post this morning focused on the major flaw in Richmond, California’s plan to use eminent domain for underwater mortgages, but it is always not a bad idea. Eminent domain could have a beneficial use in the housing market.

First, let’s look at a simple housing market. If an underwater borrower falls behind on his payments, the lender (the bank) may decide to either foreclose on the property or to restructure the loan. Foreclosures are costly and time-consuming for banks so sometimes, banks will choose to write down the principal of the loan so that the homeowner becomes back above water and can refinance. The homeowner then makes payments to the bank on his refinanced loan. The bank doesn’t earn as much as it did had the borrower stayed current on the original loan, but it still earns more than if it had gone through with the foreclosure.

But this system becomes a lot more complicated when loans are securitized and sold off to many different investors. This creates a collective action problem. If the government – or any company – wanted to write down the principal of mortgages to bring them back above water, it would have to acquire almost every tranche of the mortgages. If just a few investors refuse to sell, the firm would not own enough of the loans and would be unable to write down the principal. Thus, no company wants to devote its resources to contacting and coordinating with many investors without any guarantee of a payoff at the end. This is a classic collective action problem.

There are also three other small yet important problems that eminent domain solves:

1. Servicer incentives. Banks normally outsource many aspects of their lending program to servicers as banking activities become more complicated. For instance, servicers collect payments, pay taxes, modify loans and supervise the foreclosure process. Unfortunately, servicers aren’t looking out for homeowner interests – they care about their own bottom line.  This is a problem, because servicers earn the most in fees when borrowers are delinquent or during the foreclosure process. This gives servicers an incentive to not help borrowers become current. It’s also costly for servicers to modify a loan so even if a bank and the borrower both are in favor of principal reduction, the servicer may stand in the way.
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2. Pooling and Servicing Agreements. A further problem is that servicers are limited in how much they can modify loans by pooling and servicing agreements (PSA). Most loans have been securitized and sold off to many investors, but this creates a problem: investors don’t want the servicer to make huge changes to the loan without their approval, but also want to give servicers some flexibility to make minor adjustments. The rules for what servicers can and cannot do are outlined in the PSA that accompanies the mortgage. Most PSAs only allow the servicer to modify up to five percent of the loan without supermajority approval from investors. If servicers want to significantly reduce the principal on the loan, they must spend resources coordinating with numerous investors, without any guarantee that investors will ultimately approve the principal reduction. The high coordination costs offer little reason for servicers to modify the loans
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3. Tranche Warfare. A little known problem with principal reduction is that once the loan is securitized, different investors have different appetite for principal reduction. For instance, investors who own the senior tranches of a loan are most likely to be paid off  and may not want the servicer to modify the loan. The owners of the junior tranches, on the other hand, are less likely to receive payment and have greater incentives to reduce the principal. If the servicer does make significant modifications, it is giving the owners of the junior tranches preferential treatment at the expense of investors in the senior tranches. The servicer is technically supposed to represent the interests of the mortgage owner, but when there are multiple owners and their interests diverge, the servicer is left with few acceptable options. At the extreme, investors in the senior tranche could sue the servicer if it modifies the loan. Thus, many servicers have been hesitant to modify loans for fear of legal action against them, even if the majority of owners of the mortgage would prefer to modify it.

Eminent domain solves all three of these problems. Since the municipality owns all parts of the mortgage, the potential for tranche warfare no longer exists (solving problem No. 3). In addition, the city does not need a servicer and does not have to use a PSA so the limitations of the agreement no longer exist as well (solving problems No.1 and No. 2). Most importantly, the collective action problem associated with high cooperation costs is eliminated as well.

Since the city or company is a single entity, it does not have to worry about wasting resources coordinating between many investors. Instead, eminent domain requires all investors to sell at fair market value, eliminating the risk that a few investors defect and refuse to reduce the principal. Eminent domain solves the collective action problem.

That’s where the value of eminent domain is in the housing market. However, it requires that the government to at least offer a fair market value – something Richmond is not doing. Why is Richmond not doing it? Because the only way Mortgage Resolution Partners (MRP), the firm supplying the capital for the proposal, will profit is by paying below market value. Without those profits, MRP would not be interested in the deal. By itself, Richmond doesn’t have the funds to purchase the loans at fair value. It needs MRP’s financial backing and in return, it’s ripping off the original investors so MRP can profit. That’s why this deal is unconstitutional and will surely fall apart in the courts. But don’t overlook the fact that done correctly, eminent domain can be a powerful tool to overcome the collective action problem in modifying loans. It just wasn’t done correctly here.