Housing prices peaked more than six years ago, in April 2006—meaning that the housing bust has now lasted longer than the post-millennial housing bubble. The Obama administration’s failure to deal with the legacy of debt continues to douse any hopes of recovery. It poses another danger, too. As the purveyors of conventional wisdom refuse to proffer reasonable remedies to a solvable problem, more creative people can credibly present radical—and completely misguided—solutions to increasingly desperate local governments. The latest such gambit: using eminent domain as a tool to rescue underwater mortgages.
It doesn’t take a genius to see the biggest problem afflicting the economy. During the housing bubble—say, starting in 2000—home prices more than doubled on average. The high prices didn’t reflect any real value or wealth, just an easy-money world. During the same time period, housing debt exploded, increasing by 97.2 percent. And even as house prices faltered, lenders and investors seemed oblivious. Housing debt rose another 12 percent before finally stalling out in spring 2008, when investment-banking giant Bear Stearns collapsed. Today, outstanding mortgage debt remains 2.7 percent higher than it was in the spring of 2006.
People haven’t just lost their ephemeral wealth; they’ve lost 20 years’ worth of savings and investments, mostly in their homes. But they haven’t shed their debt, which is weighing down new investing and spending. Americans have been variously unable or unwilling to spend or invest, thus triggering higher unemployment, since investing in new projects and buying goods and services creates jobs.
The problem, then, is easy to identify: too much private-sector debt. And yet we’re stuck, and have been stuck for half a decade now. Why? Banks and investors don’t want to reduce the amount of money that homeowners owe, because it costs them money. An individual homeowner has little negotiating power over her bank, and “walking away” from this bad investment to get out from under the debt carries significant personal costs, from having a bad credit rating to uprooting children from school.
The old adage is that if you owe a bank $1,000 and are unable to pay, it’s your problem, but if you owe the bank $1 million, it’s the bank’s problem. It turns out that if everybody collectively owes the banks $10 trillion, it’s everyone’s problem—except, apparently, the banks’.
Enter an outfit called Mortgage Resolution Partners. MRP, whose executives hail from the tech, real-estate, and financial industries, thinks it has hit upon a way to break the impasse. The company is counseling hard-hit local governments, including California’s San Bernardino County and two cities within the county, Fontana and Ontario, to use the power of eminent domain to seize mortgages from existing investors, write down the mortgages’ value, and sell the lower mortgages to new investors.
The argument is seductive. Governments can use eminent domain to take private property to further a public purpose—in this case, to jump-start local economies. As the MRP folks say, keeping people in their homes “benefits the entire community.” They argue that mortgages qualify as “property,” so local communities can seize mortgages while leaving the real estate itself in homeowners’ hands, eliminating the human costs of dislocation. MRP says it would encourage local governments to snatch only mortgages whose borrowers are current, meaning that borrowers won’t receive a reward for strategically defaulting on their loan.
MRP is counseling communities to start with mortgages that are particularly good candidates for government seizure—loans that have what economists call a “collective-action” problem. The contractual language behind the securities invested in the mortgages either prohibits reductions in the amount that homeowners owe or requires unanimous investor consent for such reductions, something that has been impossible to achieve. The people who wrote the contracts never thought that such reductions on a mass scale would be necessary, since—as they and most others believed—housing prices could only go up.
Best of all, the program carries no cost for cash-strapped cities, towns, and counties. It would be “privately funded” and require “no taxes or funding whatsoever from communities or homeowners,” MRP says. No one has taken MRP up on the proposal yet, but someone probably will. “It’s time to give eminent domain a try,” New York Times columnist Joe Nocera declared.
What could go wrong? Lots. First, MRP’s eminent-domain plan relies on a top-down assessment of how much a house is worth, not on market signals. Local governments would acquire “deeply underwater mortgages at a fair market value that is determined by an unbiased court,” MRP says. But courts cannot decree a market; only individual homebuyers can do that. Advocates of the program would prefer low prices. After all, the lower the price, the more room for new investors to profit. Further, an “unbiased” judge might base his verdict of what houses—and thus mortgages—are worth on recent foreclosures, including those of properties abandoned for months or years. Such a top-down undervaluation could be devastating to traumatized housing markets, as it would affect the ability of new homebuyers to get mortgages. What bank would approve a mortgage to a new homeowner that’s higher than the value a judge has assigned to mortgages on comparable houses? And MRP likely would counsel communities to act not just once, but in waves, as more cities and towns show interest and as new investors provide more money. The threat of months’ or years’ worth of seizures could deter private investors from purchasing property.
Second, MRP has said that it would first target only mortgages whose investors are in the private sector. That is, MRP would leave government-backed Fannie Mae and Freddie Mac mortgages alone for now, though communities would be free to go after the government-backed agencies in the future. This would send an unmistakable signal to future mortgage lenders: stick with the government or risk big losses. That’s a terrible message when the government’s supposed goal is, eventually, to reduce Washington’s near-monopoly on the housing market. The strategy also raises equal-protection questions. Why should one homeowner suffer under a big loan while her neighbor gets a deal, just because one neighbor has a Fannie Mae mortgage and the other has a “private-label” mortgage? These discrepancies likely would lead to court fights, prolonging housing-market uncertainty.
A third problem is that many of the homeowners whose mortgages municipalities would seize also have second mortgages. These second mortgages—most held by banks, not investors—are supposedly junior to first mortgages. Legally, they face complete losses when first mortgages show any loss. But MRP proposes not to force second-lien holders to suffer their full loss, instead giving them a “sweetener.” This approach may sound like a good compromise, but it adds yet more unpredictable political risk to the investment world, confusing people and institutions with money to deploy when they’re already paralyzed by confusion.
Finally, it’s not clear that seizing a home under a “public-purpose” argument would pass master with a court, anyway—or even that it should. Cities like New York, which have happily kicked people out of their homes in recent years to achieve such nebulous public purposes as building a basketball arena, might object to the fact that keeping people in their homes is now an eminent-domain justification. Moreover, if residents’ rights trump property rights, a town could just as easily seize an apartment building whose landlord wants to raise rents and hand it over to the tenants, achieving the same “public purpose.”
The real tragedy in all this is that we have no reason to resort to ever more extreme housing-market fixes. We’re doing so because of an utter lack of political and financial leadership. Last week, for example, bank and mortgage-securities trade groups sent the San Bernardino County Board of Supervisors a letter warning that mortgage seizures would be “immensely destructive to U.S. mortgage markets” and would “restrict the flow of credit” to homebuyers. Fitch Ratings sounded a similar warning. Desperate city and county officials, who have seen foreclosures and blight spread while buyers struggle to find financing, can be excused for greeting such warnings with laughter. Isn’t it a little late to worry about harm to mortgage markets—harm that the industry itself helped cause with its unworkable contracts and its refusal even to try to reduce the amount of money that people owe?
Meanwhile, banks and investors don’t like principal write-downs for a perfectly rational reason, even when they are legally able to do them: the government has encouraged them to wait. The Federal Reserve has kept interest rates at zero percent for nearly four years, allowing banks and investors to borrow cheaply and to keep old, bad assets (including mortgages) on their books and hope for the best. The U.S. government hasn’t used its power over Fannie and Freddie to reduce mortgage balances for borrowers, probably because it has already promised Fannie and Freddie’s lenders that they won’t suffer any losses, so taxpayers would have to pay for private-sector mistakes. Moreover, Washington’s all-purpose answer to the housing crisis is to hope that house prices will somehow recover their magical bubble-era values, and to do everything in its power, and then some, to make that happen. Since the financial crisis began, the Fed has amassed an $855 billion portfolio of mortgage-backed securities—and has tried to keep their value going up, not down.
You can’t blame banks and investors for hoping that Washington succeeds in achieving the impossible. Only very brave or foolish investors fight the Fed, or the feds. There’s so far little sign of danger, either, that a change in the White House will make much difference. Republican presidential challenger Mitt Romney’s approach to both banking and housing has been to ignore these electorally perilous topics. When everyone cowers at sane solutions, we shouldn’t be surprised that crazy ones materialize.