It has now been six years since U.S. residential real estate prices peaked and then plunged. Housing values have dropped nationally by 30 percent and in the hardest-hit communities by more than 50 percent. Yet while home prices have fallen, the obligations that most had to incur to buy homes under inflationary conditions are largely fixed. Millions of Americans now languish in the shadow of debt, draining demand from the economy. That, as Mike Konczal argues, is the principal cause of our nation’s—and much of the globe’s—ongoing slump.
Against this bleak backdrop, nearly everyone knows what needs doing. Mortgage loan balances must be written down to bring homeowners above water. But federal efforts in this arena have been so inept or halfhearted as to be laughable, and Edward DeMarco, who oversees Fannie and Freddie, is so obsessed with “moral hazard” that he rejects writedowns entirely.
If the feds are not up to the task, we have to go local. That is, municipalities have to use eminent domain authority to force sales of underwater securitized loans and then modify them in order to keep residents in their homes with sustainable debt loads.
The securitization industry of course opposes this, and its interest groups—the American Securitization Forum, the Securities Industry and Financial Markets Association, and others—have been promoting misconceptions about eminent domain in order to discredit it. Chief among these is the notion that someone must lose if anyone is to win.
But we needn’t rob Peter to pay Paul. To see why, one first needs to understand that we are dealing with a wasteful collective action problem. A collective action problem occurs when everyone in a group experiences avoidable loss even when acting rationally: even rational actions can aggregate into bad outcomes when not coordinated by some collective agent. Bubbles, busts, inflations, and deflations are all cases in point. Our housing price hyperinflation is another, which is why DeMarco is so terribly wrong. No homebuyer could have single-handedly ended the housing price bubble; each had to pay the market rate. Everyone’s doing so drove prices higher.
We needn’t rob Peter to pay Paul.
We wouldn’t be in such a bind if all of our home loans were held by individual banks. Where deeply underwater loans are not securitized—that is, held entirely by a single lender—there are no collective action hurdles, and principal is written down to the point at which borrowers have equity in their homes and can pay down their debts. Why? Because bank executives know that underwater loans default in high numbers, which dramatically lowers banks’ expected returns. They have strong incentives to write down loans and cut their losses.
Now consider another class of underwater mortgages: securitized loans held, ultimately, by millions of investors. These loans, which now account for the great bulk of deeply underwater mortgages, are typically not written down. That’s because the millions of investors in these pools cannot readily find one another, convene, and agree either to write down the loans or sell them to parties who can. This is a clear collective action problem, so we empower trustees and servicers to act as their agents, but even these agents don’t write down or sell off the loans. They should, but they can’t because the pooling and servicing agreements under which these loans were combined—drafted as they were during the bubble when few expected a crash and securitizers pushed product in haste—typically prohibit or otherwise prevent their doing so.
Enter the eminent domain plan, which enables an agent other than the trustee or servicer—in this case, a government—to sidestep these market-clogging contracts and refinance debt so that markets can properly price assets and recoup value. It is this recouped value that can benefit everyone.
Everyone? Yes. Lien-holders who are first in line receive fair-market value for their presently unmarketable assets. Investors in the new written-down loans—including current bondholders—get a return on the funds that they lend to the cities to pay the first lien-holders. Homeowners get positive equity and sustainable debt. Neighbors stop losing on the values of their homes, cities maintain property tax bases, and everyone now suffering spillover loss finally sees real recovery. Even second lien-holders have a chance to gain, whereas in foreclosure they get nothing.
Eminent domain is not the zero-sum game its opponents make it out to be. We can pay Peter and Paul—and everyone else.
Robert Hockett, Professor of Law at Cornell University and Fellow at the Century Foundation in New York, is a designer of the eminent domain approach to underwater mortgage debt. More on the plan can be found, e.g., in his recent paper for the Federal Reserve Bank of New York on the subject.
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