It's a creative solution, to say the least. Many existing homeowners will be able to stay in their homes and the resulting stability might move the local economy forward.
But saying that it might work is not the same as saying it's a good idea.
Eminent domain can be traced back to the Constitution and our British forebears. It was established to prevent landowners from holding out for excess value on projects that were good for society. A 10-acre parcel that is worth $500,000 two days before the city wants to build a park on it should not be worth $1 million once this intention becomes known. That makes sense: The landowner was trying to take advantage of the city.
So, applying this to underwater mortgages, the government will tell a homeowner with a $250,000 mortgage, living in a house that's now worth $150,000, "POOF! You now owe only $150,000."
What's not to like? But what happened to the other $100,000? The government just made it disappear, the proponents say.
Legally speaking, that's correct. As the home owner's debt, it has been made to disappear. It's also been made to disappear as an asset to the mortgage lender - a "forced refi" at current market prices.
Many people believe that the mortgage lenders are the cause of the current economic stagnation because they are holding out in hopes that, once home prices increase again, they will get their money back. It's a game of sorts. If there are four companies that own all of the mortgages and three of them give up and write off the excess value of their mortgages now, things might improve and the holdout company would be able to get a bigger fraction of its mortgage value back.
But each of the mortgage lenders wants to be the holdout that does a little better and so none of them write off the excess value and move on. The housing market and the rest of the local economy are stuck.
Enter the government and eminent domain. The government forces all of the lenders to refinance, no one is allowed to hold out, and things can move forward.
I'll tell you frankly, and with some hesitation, that this might work. One thing that governments can do is take away the strategic advantage that individuals play for - in this case, the desire of each lender to be the holdout - and force everyone to accept the same terms.
There are at least two problems with this scenario, however. First, fairness: All of the underwater homeowners are gifted an attractive refinance by government decree. What do you say to the people who didn't over-borrow or arranged their own refinancing at less attractive terms? Aren't you telling them that they were suckers for not waiting for the government to absolve them of their debts?
Second, the government has reset the rules. Having shown a willingness to rewrite home mortgage contracts en masse, the government will add a new risk factor to all future home purchases.
When you get a mortgage to buy a home, the home is the collateral. If you can't pay the mortgage, you lose the home and the mortgage lender gets it. The size of the mortgage depends on the value of the home. But the lending institution is only an intermediary; that borrowed money belongs to someone else and the lender needs to return it, so it will only lend an amount that it is pretty sure it can get back.
If the government is willing to force lenders to accept lower values, lenders will include that in their calculations from now on.
Put differently, lenders will not lend as much after the government puts this policy into effect. The use of eminent domain might - might - fix one problem now, but it will certainly create another one in the future.
If the government wants to do something for the betterment of its current and future residents, it should buy the mortgages from the lenders at the current mortgage value and then refinance the mortgages it has acquired. That would be more expensive, but it would assure lenders that they will not be wary of writing mortgages in the future.
And the fairness problem? The "suckers" can take that into account when they vote!