Eminent domain abuse threatens the mortgage industry

Back when San Bernardino made headlines by considering the seizure of “underwater” mortgages under the expanded eminent domain powers ratified by the notorious Kelo decision at the Supreme Court, I had a feeling this bad idea would be going national.

The Wall Street Journal reported on Thursday that, indeed, “Cities from San Bernardino to Chicago are contemplating this land grab that would seize certain mortgages, write down their principal value, impose losses on the holders of those mortgage securities, and then hand them off to another private company to repackage at a profit.”

This is nothing less than theft.  The government would be seizing property – in this case, financial property, rather than physical real estate – from its lawful owners, forcibly altering the value of the property according to political imperatives, and giving it to different private interests for their own profit.  That’s precisely what Justice Sandra Day O’Connor warned would happen, in her dissent from the Kelo decision.

Fortunately, Fannie Mae and Freddie Mac regulatory honcho Edward DeMarco is alert to the danger, and the Journal praised his vigilance:

On Wednesday Mr. DeMarco’s Federal Housing Finance Agency issued a timely public notice of eminent domain’s potential to “revise existing financial contracts” and reduce the value of $136.5 billion’s worth of (privately backed) mortgage-backed securities held by Fan, Fred and the 12 Federal Home Loan Banks. Taxpayers could end up taking losses, and one of Mr. DeMarco’s legal duties is to protect against such losses.

The warning said there is the potential impact on “millions of negotiated and performing mortgage contracts,” as well as questions about “fees and costs” and federal and state consumer protection laws, and potential damage to private investment in housing. The agency’s warning also raised the not-so-small matter of property rights, which tend to be ignored when politicians are looking for a free lunch.

The temptation for some variation on the Kelo mortgage-seizure scheme will remain powerful.  The financial ocean atop those “underwater” mortgages is deep.  People who find themselves owing more than the value of property they previously viewed as a smart investment are naturally unhappy.  The banks holding all that paper make inviting, unpopular, deep-pocketed targets.  The end result would be a massive loss of value to long-term assets, not guys in ski masks marching out of bank vaults with bags of cash gripped in their sweaty fists.

But the damage to contract law in general, and the fragile mortgage industry in particular, would be horrendous, and long-lasting. The crippling hit to business and credit confidence would probably endure until the Kelo decision was overturned.  What financial entity would want to risk making loans when it knows the government could simply seize its assets and re-distribute them, because the political class decides that the terms of fairly negotiated contracts signed by consenting adults are suddenly “unfair,” and a lot of people who would be on the sunny side of such debt redistribution agree?