New Twist on Centuries-Old Law Offers Underwater Homeowners Hope

Underwater mortgage
Underwater mortgage

Government has long used its powers of "eminent domain" to seize private property for projects it considers in the "common good," like roads or schools. Two cities in California, however, are putting a new spin on this centuries-old law, one that may help get besieged homeowners out of their underwater mortgages not only in California, but across the country.

But first, the inaugural cases have to make it through the courts, and that's not going to happen without a fight.

Help for the Drowning Homeowner

The Wall Street Journal reports that the idea is to use eminent domain to seize the distressed properties, pay the lenders off at a price agreed to by the courts, then resell the property back to the original homeowner at a fair market value.

Homeowners are said to be "underwater" or "upside down" on their mortgages if they owe more on their homes than the homes are worth. The two California cities considering this groundbreaking application of eminent domain are Fontana and Ontario, both of which are in San Bernardino County, the nation's 12th largest county by population. More than 40% of homeowners there are upside down on their mortgages.

Just Slip Out the Back, Jack

When homeowners are underwater, there's always a danger they might decide to just "walk away" from the house, take the credit-rating hit, and go start over somewhere else. Of course, they wouldn't be able to buy again immediately, but they might be able to rent. Regardless, it gets them out of a frustrating or unsustainable financial situation -- one that can also put the municipality into a similar situation.

Abandoned homes drive down neighborhood property values, potentially putting more homeowners into financial binds, which can persuade even more of them to pick up and go. This is what officials in Fontana and Ontario see happening in their towns and are trying to reverse or at least halt.

California: An Ideal Testing Ground

The thought of having an upside-down mortgage suddenly turned right-side-up is an undoubtedly happy one for homeowners, but not for the original lenders, who foresee their balance sheets being decimated by substantial reductions in monthly mortgage payments. That's because the program is not aimed at defaulters, with whom the banks may have had to negotiate for a reduction in payments anyway. For homeowners to qualify for this new plan, they will have to be current on payments.

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As such, once the first of these eminent-domain property seizure cases go to court, the banks will fight back vigorously. And as this is the first time anyone has tried to use eminent domain in such a manner, it's impossible to say how the courts will rule, though some have their guesses.

Carrying out these seizure-resell processes will require that municipalities team up with private investors, which will help facilitate as well as profit from the deals. The Journal reports that at least one such partner, Mortgage Resolution Partners out of San Francisco, is optimistic: "California legal precedent and political posture," the company has stated, "favor the program and constitute an ideal proving ground."

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Like, a Totally Radical Solution, Dude

Politically, culturally, and economically, much of what the rest of America eventually gets around to doing begins in California. If this plan by the leadership of Fontana and Ontario succeeds, it could affect up to 3 million homeowners for starters. After that, who knows? Such a strategy could even be a way for the rest of the country to extricate itself from its housing mess.

It's not often the government comes up with an "ingenious rescue plan," and the dysfunctional nature of California's politics in general argues against the genesis of this one, yet here it is. With some of the worst foreclosure rates in the nation, California may have helped lead the rest of the country into the housing bubble, but now at least it may be helping to lead it out.


John Grgurich is a regular contributor to The Motley Fool.