A solution for underwater mortgages: Eminent domain

By Robert Hockett
June 19, 2012

It has been nearly six years since U.S. home prices peaked and then plunged, and still the nation’s mortgage markets remain mired in slump. Despite occasional signs of improvement in some localities, the S&P Case Shiller Index shows home prices down 9 percent from their previous post-bubble high – itself very low in relation to trend. Meanwhile a backlog of some 400,000 homes awaited liquidation at the end of 2011, and an additional 2.86 million mortgages were 12 or more months delinquent. That’s a “shadow inventory” of 3.25 million homes already foreclosed or now facing foreclosure – an inventory that weighs on home prices, families and neighborhoods alike.

It also weighs on our economy, at the city, state and national levels. As a recent Federal Reserve Board white paper and other sources abundantly demonstrate, foreclosure and slump in the housing markets feed back into the broader economy by diminishing wealth and consumer spending. That lowers growth and employment – bad enough in themselves, but also sweeping more mortgages into the wave of defaults. Hence the familiar downward-spiraling “feedback loop” of high foreclosure rates, causing low growth and employment, causing yet more foreclosure, and so on.

Easily the worst source of drag is the large class of “underwater” mortgages – loans on which more is owed than the underlying post-bubble housing collateral is now worth. It isn’t hard to see why. Wrought by the rise in housing prices until 2006, the so-called wealth effect supported consumer spending even when wages and salaries stagnated. But it runs in both directions: Homeowners with “negative equity” cut their spending the most. Even tax cuts, rather than flowing toward employment-supporting consumer expenditures, go toward trimming back overhung mortgage debt. That’s why the 2009 stimulus did so little.

In light of these truths it is now widely appreciated that principal writedowns will be required for a broad swath of underwater mortgages. Even many creditors – the prospective bearers of writedown-wrought losses – understand and embrace this. For they are better than defaults, which underwater mortgages do at high rates. Indeed for most underwater mortgage debt, principal writedowns maximize expected value.

So writedowns will have to be done. The question is how. Unfortunately, a host of what lawyers and economists know as “collective action problems” stand in the way of the win-win solution here. For one thing, the securitization agreements pursuant to which many modern mortgage loans are pooled and then sold often require unanimity or supermajority votes among mortgage-backed securities (MBS) holders before loans can be modified. And today’s fragmented owners of MBS cannot even find one another, much less reach agreement on what’s best for them. For another thing, these same agreements likewise typically prohibit loan servicers, who act on behalf of the loan holders, from modifying as well.

But there is more. Many underwater homes are subject to second liens that secure home equity lines of credit (HELOCs) taken out by mortgagors to supplement stagnating wage incomes during the housing boom years. First liens don’t benefit by modifications unless second liens modify too. But second liens feel less pressure to modify because borrowers, now strapped by post-bust liquidity needs, pay them off first – reversing the legal order of creditor priorities. As if to add insult to injury, the second lienholders often are banks – the same banks that service the first lien loans. That is a massive conflict of interest. And there are yet more obstacles to creditor-benefiting coordination.

What then to do? To solve a collective action problem, we need a collective agent. That’s what governments are. But which government? For a number of reasons, the federal government is presently not the right choice. The federal HAMP and HARP programs, for one thing, don’t prioritize principal writedowns. When they do use them, moreover, they do so by paying the servicers – in effect bribing them to do what is already in the best interest of their principals. The GSEs – Fannie and Freddie – for their part, are prevented from entertaining writedowns by their regulator – FHFA – a regulator that seems to be hostile to writedowns and would do so at unnecessary cost, through HAMP, in any event.

Who then is the proper collective agent? The answer is right before our noses: the cities. Using their traditional eminent domain authority, municipalities can “take” – it’s a constitutional term of art – underwater mortgages from holders for fair market value. They can then write down the loans to just under the values of underlying homes, bringing these back above water. They can finance these takings with moneys supplied by investors, who then are repaid on the refinanced mortgages. By working with the cities in this way, investors effectively sidestep all the collective action hurdles that now prevent them from doing what most would wish to do anyway – write down principal to maximize loan value.

Is this sort of thing actually done? Of course. Cities take property for public use at fair market value all the time, and do it with all kinds of property – tangible and intangible, contractual and property-related. The question is only whether fair value really is paid and a proper public purpose justifies the forced sale. Preventing a self-amplifying tsunami of foreclosure, mass homelessness, blighted property, lost revenue base, and ultimate retraction of essential city services – in short, urban blight on a disastrous scale – is widely recognized in the courts as the most compelling of public purposes justifying eminent domain use.

Seven years ago, in its infamous Kelo v. City of New London decision, the U.S. Supreme Court upheld a controversial exercise of the eminent domain authority by a city that ousted its residents from their homes for the benefit of a private developer, all in the name of revitalization. The promised renaissance never panned out, and the affected residents – most of them elderly and anything but wealthy – were ultimately uprooted and traumatized to no purpose. How redemptive it would be, against that sad backdrop, to see cities employing the eminent domain authority to keep residents in their homes this time around – and maximizing the values of more realistically valued loans in so doing.

Our nation was long ago founded on the principle that state and local governments are, for some, even many, purposes, better vested with authority than is the federal government. They are the most directly in touch with their residents’ day-to-day struggles and needs, and they are the most directly accountable to their electorates. A local eminent domain solution to the nation’s ongoing underwater mortgage crisis looks, accordingly, to be just what the proverbial doctor would order. For that massive collective action problem that lies at the heart of our ongoing mortgage inertia, municipalities are the necessary collective agent.

Illustration: Elsa Jenna.

32 comments

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The most interesting part of this approach is that it can be tried.

Worst case scenario one city ends up being an even bigger mess than it already is; but as compared to the overall size of the problem that is relatively cheap for trying something.

Of all the many suggestions out there few can be tried at a small scale to prove the concept; this one can. Will it work; dunno. Is it worth the cost of an experiment; yeah.

Posted by Hamer | Report as abusive

Many thanks for the comments thus far.

To those who fret about taxpayer expense, I urge that they read the full layout of the plan here: http://www.lawschool.cornell.edu/spotlig hts/Hockett-Reveals-Plan-to-Address-Unde rwater-Mortgage-Loans.cfm. The short playing version is that all expenses are covered by private investors, who are willing to foot thie bill precisely because the plan boosts the value of the underlying mortgage loans by writing down principal. (Underwater mortgages default at very high rates.)

To those who (I must say, comically) equate eminent domain with ‘communism,’ I suggest a quick look at the Due Process Clause of the 5th amendment to the US Constitution. Eminent domain is no more and no less ‘communist’ than are the Constitution and the US commonlaw itself.

Posted by RobertHockett | Report as abusive

I think eminent domain should be outlawed. Land ownership should be true and absolute.

Posted by silverwolf1977 | Report as abusive

You never really own property, you’re simply renting it from a government. If you fail to pay your taxes, your property is taken away from you.

Posted by Andvari | Report as abusive

Another pie in the sky plan… there are over $11 trillion in real estate loans on the books… and well over $2.5 Trillion are now under water… eminent domain on that many loans… will happen right after the Cubs win a World Series… How about a make sense proposal of Mark-To-Market for all such loans, keeping the people in their homes… stabilizing the housing market and enabling the sector once again fuel new jobs…

Posted by GotDOCG | Report as abusive

Eminent domain taking is for public USE, not public purpose. As someone else said, nice sleight of hand.

Posted by Mithuna_Khon | Report as abusive

Sorry to correct you Sarko, but communism has favoured hyperinflation as the most satisfactory means of impoverishing the middle classes historically.

Posted by datchary | Report as abusive

The use of eminent domain to take the property of those people in Connecticut for a high end development which never got developed is actually am example of fascism not communism. Communism is when the means of production and ownership is all controlled and owned by the government in the name of the people. Fascism is where a small group of corporation, with close relationships with the government own and control everything (actually, fascism is a mixed economic system with some small ownership, but most large corporation in close relationship with the government.) The land take in the case cited was nt to be used for a community park, a community hospital, a school or even a factory which would supply jobs. It was to be used to build high end luxury housing. Eminent domain has been use in the US to drive individuals off their property to benefit corporations in the name of urban renewal. Both communism and fascism are totalitarian. Under Bush-Cheney ad in those states run by Republican governors, like florida, there has been an effort to privatize prisons, public health services and schools in the name of efficiency and to reduce costs” in actuality that sort of fascist privatization always results in more waste and poor services. Lower wages, and higher profit to some friend of those in government.

Posted by JackVigdor | Report as abusive

This is absolutely brilliant, and I must say the comments about “communism” and “moral hazard” made me laugh out loud. After seeing the taxpayer bail out the stupid bets on Wall Street while bonuses flooding to hedge fund managers, it is clear communism is alive and well for the rich! But the beauty and irony of using the right-wing Kelo decision to actually HELP the little guy is delicious. Since it doesn’t help the banks and big investors (at least directly), I would expect the SupCt would use the obligation of contracts prohibition to squash this fantastic idea, however.

Posted by Tye15 | Report as abusive

In Ohio, Michigan, and many other parts of the so-called midwestern “rust belt,” the problem is as much the fact that there are 10s of thousands of vacant, abandoned, functionally obsolete homes that are far beyond repair that are littering neighborhoods and weighing down neighboring property values as these empty homes continue to rot, their yards turning to dumps, and the homes become venues for crime and drug activity.

Detroit, Cleveland, Dayton, Cincinnati, Flint, parts of Chicago, Buffalo, Indianapolis, etc…which are all struggling to rebuild in the wake of the foreclosure crisis, will continue to fail in their efforts until they take a step back and tear down the thousands of abandoned, decaying, and never-again-to-be-inhabited homes that are sinking the values of homes that are inhabited, and the viability of neighborhoods that would otherwise benefit from the range of programs and methods that are being attempted to revitalize housing markets in the post-foreclosure crisis era…I recommend those interested in a more viable solution than a gov. “taking” research the efforts of the Western Reserve Land Conservancy’s Thriving Communities Institute in Ohio, (http://www.thrivingcommunities… which has set up quasi-governmental entities called “land banks” that allow for the clearing of title of foreclosed, vacant properties by operation of law so that property can be resold, repurposed, or demolished depending on a case-by-case evaluation of the condition of the home itself, its neighborhood, and the local housing demand.

Posted by dbizzness | Report as abusive

It was reported in March 2010 that B of A had already spent over 2.3 billion on legal fees alone. The banks must pay property taxes on all the properties they take back (not that they are). The community blight from unoccupied housing is staggering.

These facts do not even begin to take into account the countless families and their children that are now homeless.

Most of these families could pay their mortgages at the current market value. It would be in the best interest of the banks as well as communities to modify these loans and ALL properties underwater. The legal fees saved alone could justify the price. This is not communism considering the FBI report that 80% of mortgage fraud was due to collusion and insider trading by investors and insiders.

On May 9th, 2012, Henry Walker, CEO of Farmers and Merchants Bank, stood before the Long Beach committee and stated that these proposed Homeowners Bill of Rights would continue to damage the banking industry?

In reply to that there is an old Supreme Court case; Bigelow v. RKO Radio Pictures, Inc. 317 US 251 (1946) which states that: “The most elementary conceptions of justice and public policy require that the wrongdoer shall bear the risk of the uncertainty which his own wrong has created.”

Please consider that the lenders have put themselves in this position by their irresponsible and fraudulent behavior, yet their economic advantage still gives them room to bully the homebuyers who simply want to live in their homes.

They have foreclosed on homes they do not own. They have foreclosed on homebuyers who did not have mortgages. They have foreclosed on homebuyers who thought they were paying on time, but due to some glitch were behind only $104.00

And while these were obvious wrongs, the cost and emotional stress it cost the homebuyers to correct these wrongs is…again…staggering.

People need to understand….this is not “business as usual” this is blatant, unmitigated fraud and in lieu of thousands of bankers and Wall Street execs in jail there needs to be restitution to the buyers.

This is an excellent plan and should be seriously considered.

Posted by RenoiraS | Report as abusive

Just the fact that private homes are in waste lands in the areas “dbizzness” mentions – even if the abandoned buildings are razed – will mean those survivors will still have little or no market value.

The rules for real estate value in this free market economy have always been “location-location-location”.

The rule is so unremitting – literally – that the wrong side of the street can mean the difference between a going commercial property and a failure. The “wrong people” (defined by snobbery, middle class values and racism) could doom excellent housing stock almost over-night.

We live in an economy that caters to whims, speculation and no foresight and is easily driven by fear (even imaginary ones), and no real planning for the downtime of an economy. Planning Board Master Plans are not really plans – more inventories with suggested locations for ,usually, privately funded land use. They always adopt the fashionable or market driven solutions. Now it is too late to repair the damage due to poor planning. The municipalities – especially suburban areas – want what looks pretty and they think will preserve their real estate values and don’t usually take into consideration fuel costs or pedestrian convenience. Municipal planning boards can also be bribed to do what big developers want.

Real estate has been dominated by speculation for the past 50 years and if it goes down – the speculators flee and forget the rubbish they left behind. It is for the municipalities to clean up the wreckage at the tax payers expense.

Those areas cannot be reclaimed without massive intervention by State and Federal programs that will rebuild the waste lands such, that very skittish private builders and large developers will risk their money on them. The big guys don’t like to take big risks. It’s nonsense to accept a popular notion that large developers or bid business will risk fortunes until they are sure the risks are well understood and as small as possible. They have investors to satisfy and they have to be careful or they will loose their jobs.

If those neighborhoods ever come back, it can only happen if the business that provides employment in the area starts to thrive again. Otherwise it was not built to last forever and will revert to the bare ground. Everything in this country – including private homes – has been built for an economic purpose and it purpose dies so goes the stuff it built. This is the free market ethic that built the physical environment for the past 150 years. The speculative fever was something I never saw so strongly until about 30 years ago.

The populations are also disposable – the planning boards never think about what might happen to the residents if the economies of their area start to whither.

Putting all the Bankers in jail isn’t going to work because they know the law better than their clients. They were following the law and were even trying to figure out the vagueness of it.

BTW – everything you read in newspaper articles doesn’t have to be correct and can even be planted by donations to the editors. What is journalistic ethics today? How do you know if the media has any, anymore?

Posted by paintcan | Report as abusive