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FHFA Strives to Protect Veterans From Eminent Domain

In Richmond, Calif., the local authorities have come up with a new way to fight slow home sales and declining property values: they want to use their power of eminent domain to refinance underwater homeowners. If successful, Richmond's use of eminent domain could limit the use of VA-backed mortgages.

We usually associate "eminent domain" with the ability of government to take physical assets. Traditionally, a local government might seize property to build a new road or put together land for a school. The property owner, under the Fifth Amendment, is entitled to "just" compensation.

So what does this mean for VA borrowers?

The Kelo Decision

Under the Connecticut Supreme Court's 2005 Kelo decision, the concept of eminent domain was greatly expanded. Now, said the court, local governments could seize private property and resell it to developers who would build such things as offices, malls or apartments. According to the decision, the new construction justified the use of eminent domain because the end result would be a larger tax base.

The Kelo decision can be fairly described as one of the most contentious real estate decisions ever made by the court. It effectively allowed government to take private property from one person and give it to another private party. That's very different from taking private property for public use.

If governments can seize real estate by eminent domain, then why not mortgages? That's the question raised in Richmond, Calif. The city has offered to purchase at discount almost 650 loans from investors with offers they can't refuse. Borrowers will then refinance smaller loans at lower rates, thus reducing the foreclosure rate and increasing the tax base.

The discounts may well be "just" compensation because of property value declines experienced in the city. The ability of the city to condemn loans, and the price they are willing to pay, will unquestionably wind up in court.

VA Loans and Eminent Domain

The VA insures loans, it does not actually make them. If a loan goes bad, an investor who owns a VA mortgage can suffer a loss because the VA does not provide 100 percent protection.

If Richmond goes through with its eminent domain mortgage program, the sure result is that few lenders will offer loans in the city and few investors will buy such paper. Already, a government regulator, the Federal Housing Finance Agency (FHFA), says the use of eminent domain to restructure existing mortgages represents "a clear threat to the safe and sound operations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks."

"On balance, use of eminent domain for addressing contractual rights or intangible rights has been rare," says FHFA.

A Lot on the Line

FHFA says that if any community seizes loans through eminent domain it may "limit, restrict or cease business activities within the jurisdiction of any state or local authority employing eminent domain to restructure mortgage loan contracts."

Translation: We won't buy loans which result from eminent domain – including VA mortgages.

The stakes are high. If Richmond uses eminent domain to seize loans – and if it succeeds in court – other jurisdictions will adopt similar policies. In such a situation investors might elect to avoid buying loans in areas impacted by new eminent domain policies, effectively stalling local real estate markets.

It's a mess that threatens all forms of real estate financing, the stability of the housing market and how homes are valued. It also threatens investors because in a sale situation the current market value of the loan would have to be recorded – and for many loans in foreclosure centers that means showing a loss.

All in all, let's hope someone blinks before the eminent domain argument goes much further.