If one wanted to craft a strategy to make the home-mortgage market even less stable, increase already-unsustainable public debt, and erode private property rights even further than we have already seen, it would be hard to top a new idea from California, of all places.  Two cities have fashioned a plan to use eminent domain not to seize real estate, but to seize the mortgages on them.  Call this … Kelo meets Hugo Chavez:

Eminent domain allows a government to forcibly acquire property that is then reused in a way considered good for the public—new housing, roads, shopping centers and the like. Owners of the properties are entitled to compensation, which is usually determined by a court.

But instead of tearing down property, California’s San Bernardino County and two of its largest cities, Ontario and Fontana, want to put eminent domain to a highly unorthodox use to keep people in their homes.

The municipalities, about 45 minutes east of Los Angeles, would acquire underwater mortgages from investors and cut the loan principal to match the current property value. Then, they would resell the reduced mortgages to new investors. …

For a home with an existing $300,000 mortgage that now has a market value of $150,000, Mortgage Resolution Partners might argue the loan is worth only $120,000. If a judge agreed, the program’s private financiers would fund the city’s seizure of the loan, paying the current loan investors that reduced amount. Then, they could offer to help the homeowner refinance into a new $145,000 30-year mortgage backed by the Federal Housing Administration, which has a program allowing borrowers to have as little as 2.25% in equity. That would leave $25,000 in profit, minus the origination costs, to be divided between the city, Mortgage Resolution Partners and its investors.

Where to start on this nonsense, given to us courtesy of David Souter?  The Kelo decision gave a legal option of using eminent domain not for public use, such as roads or utility rights-of-way, but to transfer property to other private ownership.  One can imagine that a Supreme Court that had no problem establishing that precedent would suddenly get persnickety about the definition of property subject to eminent domain, not unless the court in question would like to take a second chance at getting that decision corrected and the precedent undone.

If cities began doing this, it will create a number of problems, especially in mortgage markets, which are still unstable thanks to the 2008 housing bubble crash created by government interventions over a decade in the market.  It will disincentivize future investors, who will rightly wonder just how safe their investments will be while cities have the prerogative of simply deciding how much of their investment they should be allowed to keep.  As it works now, investors take known risks on loan securities, but this will add a huge amount of uncertainty to the investment market, and it will drive capital out at a time when mortgage lenders need more capital to get into the market.  That will force lenders to raise bond yields, which will mean higher mortgage rates for borrowers, especially for those who present more risk.

Furthermore, it will hand a carte blanche to local politicians looking to curry favor with residents — and we can expect them to use it as often as they think they can get away with it.  Nothing sells like populism, and nothing in populism sells better than “sticking it to the banks,” even when the “banks” really means lots of investors, large and small, who bought mortgage-based securities for retirement funds and the like.  On top of that, the process heightens the moral hazard of government intervention, which then encourages people to take irrational and damaging risks by expecting private gain with public loss.

In short, this is the kind of policy that is not just misguided, but positively disastrous, even when the government in question is on solid financial footing — which is hardly an apt description of government in California at any level.  What happens when no one wants to buy the mortgages seized by these cities because of the instability and risks involved?  The taxpayers will be on the hook for the principal, even at the artificially-imposed new level, and when the homeowners default on those mortgages, the cities will have to maintain the properties at taxpayer expense.

American government should use eminent domain only on real property, and only for actual and explicit public use, and pay market price as compensation.  This is a violation of private property rights on every level, and a symptom of a government transforming from the traditional American model to something much more authoritarian — and incompetent.