Helping Underwater Borrowers is Great Until it Costs Everyone Else

When state lawmakers tinker with mortgage banking rules, home owners get stuck with the bill.

California lawmakers seem determined to raise the cost of home mortgages by tinkering with the laws governing home loans.

In June, a handful of California cities started talking about seizing the loans of troubled home owners by using eminent domain — a practice governments typically use to seize property for public use, like seizing your home to build a highway. The idea is to readjust the loan amount to reflect the home’s actual value.

Then, in July, the California legislature took the multi-billion national servicing settlement that five big banks and the state attorneys general worked out and used it to create foreclosure protections that’ll apply only to mortgages on California homes.

The two moves have one thing in common: They sound like good ideas until you realize who’s going to pick up the tab for those changes — mortgage borrowers.

When individual states set mortgage servicing rules instead of following national rules, banks have to spend money to track and follow multiple rules. What’s more, banks make less money from the loans they sell to investors. So if it costs more to lend, bankers will pass on those increased costs to the consumer.

Here’s how it works

Suppose a house is worth $100,000 but has a $200,000 mortgage. Under the seizure gambit, the city would seize the mortgage, pay the investor $100,000 instead of the $200,000 that’s owed, and the home owners would get a new loan for just under $100,000 (because you still have to make a small downpayment). The program would only be used for loans that aren’t guaranteed by Fannie Mae, Freddie Mac, or FHA, which, granted, isn’t the majority of loans.

Catch-22?

On one hand, the eminent domain proposal could help home owners whose loans were seized. If you’re underwater on your mortgage but current on your payments, the city seizes your loan, and gets you a mortgage that better matches the value of your home, you’re more likely to avoid foreclosure. Not to mention that the process helps stabilize neighborhood home values.

But it’s going to cost everyone else who has a mortgage. The investors who made your original home loan will lose a lot of money and won’t want to get burned again. They’ll want more do-re-me for putting their money into mortgages that can be seized. The chain reaction ends with you.

Bottom line: Anyone getting a mortgage to buy a house or refinance an existing loan will have to pay more to compensate investors for that risk.

Put yourself in the investors’ shoes

Would you invest in California or other state mortgages if you’re unlikely to get back the amount you invested? If you do invest, you’ll want a lot more money to cover the risk you’re taking. That means we all face even tighter lending standards and higher downpayments. As it is, credit conditions are still way too tight to meet pent-up market demand.

States really need to back off and let the federal regulators do their jobs. I don’t always agree with everything the feds do, but in recent years, federally guaranteed loans have been about the only mortgage option available to borrowers. It was the feds that managed to keep mortgage money flowing throughout the U.S. during one of the most challenging periods to ever occur in the real estate market.

And sticking with one devil we know is a lot cheaper than dealing with the 50 we don’t know.

What do you think about this seizure strategy? Will it help a few and harm a lot?