Stabilize Home Mortgage Borrowers with Eminent Domain

By Lauren E. Willis [reprinted here with permission]

Edward Leamer’s “trickle up” economic plan is a good start, but if a downward spiral is a serious possibility in the economy right now, we need not a trickle but a flood. We need to quick-take homes by eminent domain, prepay mortgage balances that are not extinguished (mortgage debt beyond the market value of the home would be extinguished), and sell the homes back to the homeowners using fixed-rate mortgages with affordable monthly payments. This would eliminate today’s mortgage debt overhang, staunch foreclosures, and restore liquidity and stability in our financial markets.

To halt the Great Depression, the federal government nullified all clauses in contracts that pegged debt to the price of gold. By taking these contracts off the gold standard, debts were reduced by roughly 40 percent. Economist Randall Kroszner, now a governor on the Federal Reserve Board, examined the effects of this sweeping debt reduction and found that both stocks and bonds responded favorably. Investors and creditors decided that the elimination of debt overhang and the avoidance of threatened corporate bankruptcies more than offset the cost to creditors of receiving 60 cents on the dollar. And the taxpayer did not pay a penny.

This trick could only be performed once, now that gold clauses are out. But we still have a potent weapon against the crisis: eminent domain.

Eminent domain is the power of government to take private property for a public purpose, so long as the owner is paid just compensation. Eminent domain can be used to correct deficiencies in the market, particularly when they threaten public tranquility and welfare.

How would this work? Upon petition of the homeowners, the government would take primary residences at risk of foreclosure and then sell the homes back to the homeowners at current prices.

Because just compensation in eminent domain is measured by the market value of the property, today’s fire-sale home prices would be a boon to this plan. Lenders and investors would receive the lesser of the mortgage balance or the amount paid by the government as just compensation. Unlike newly-invented securities and other financial instruments, homes have been appraised for a very long time and objective criteria can establish market value.

For homeowners with mortgages that are underwater, the effect would mirror the debt reduction achieved when Congress nullified the gold clauses. Home values would bottom out quickly, and households looking to buy would see lower house prices.

Families that can not afford a mortgage even with a balance reduced to market price will lose their homes, but will not have the additional burden of a foreclosure or bankruptcy on their credit histories.
While some commentators seem to think that the $700 billion bailout will provide homeowners with a kinder, gentler federal government lender, the bailout primarily contemplates buying not individual mortgages, but shares of securities backed by pools of mortgages and other complex financial instruments. Unless the government buys all the shares in a pool—an unlikely proposition given that owners are spread around the globe—it will lack authority to do workouts with homeowners whose mortgages are in the pool.
The thousands of families falling into foreclosure and bankruptcy each day will continue for years, with the limited capacity of loan servicers and courts prolonging the problem. The social costs of foreclosure will roll on, increasing the tax burdens and decreasing the quality of life for all households, renter, former homeowner and current homeowner alike.

Eminent domain has the virtues of the Wall Street bailout plan without the vices.

Financial firms and other investors could no longer delay realizing losses on their mortgage backed securities and similar financial assets, but simultaneously would bring in cash from mortgage prepayments. These payments would pump liquidity back into the financial system to be lent out again.

Taxpayer money would not be spent paying Wall Street a speculative price for unmarketable financial instruments, but instead would pay market prices for houses. Investors would receive precisely what their investment contracts provided for in case of prepayments, rather than whatever they can convince their friends at the Treasury Department to dole out. Most importantly, the underlying mortgage debt overhang problem would be addressed.

This is not to say that this plan is cost-free. But so long as the government underwrites the mortgages well, with monthly payments the borrowers can afford and are therefore likely to pay, banks and investors will buy the mortgages at close to what the government pays. Using a streamlined quick-take process to take eminent domain over the houses, appraise them, buy them from and sell them back to the homeowners, give Wall Street the money it is owed, and underwrite the new, affordable mortgages and then sell them, will cost far, far less than $700 billion. Even if the government spent $10,000 on each of the approximately 5 million mortgages expected to go into foreclosure in the next three years, the cost would be $50 billion.
As the Wall Street bailout plan recognizes, a crisis that sweeps the country requires a solution of like scope. Like the abrogation of the gold standard clauses, eminent domain is a blunt instrument, one that inevitably will be overly generous to some and will hurt others. But hurting the ordinary taxpayer to be overly generous to well-heeled banks and other sophisticated investors, without even addressing the underlying mortgage debt overhang and foreclosures, is not the answer. Eminent domain would stabilize Main Street and Wall Street.

Lauren E. Willis is an Associate Professor of Law at Loyola Law School Los Angeles and an expert on the regulation of consumer financial products, including home mortgages.

Comments

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Great post, hopefully it's not too late for ideas like these.

[gillian g.]

Somewhat orthogonal to the creative ideas in this article, I've found a site that is unusually straightforward and detailed on on the topic of loan modifications (other consumer information online - much of it direct from the U.S. Treasury and related websites - is still either biased in favor of hyper-technical renditions of Obama's Home Affordability Plan or sketchy, watered-down tidbits intended for an uneducated public. I did find a site called HomeAffordPlan.com that seems to bridge the gap.

[jeff]

Yah Lauren, if you want to plunge the country into instant depression, go ahead. You don't have a clue about how this all started, do you? Don't you get it isn't about ma and pa's mortgage anymore?

Ever heard of the Bond market? All private lending to the US will cease immediately if you do this. Wait, I bet your answer to this hiccup will be some wild-ass money printing, right? Can you say Weimar?

It would be more helpful if you just shut the hell up and let the market correct itself. Take the pain now; otherwise you'll be a suicide later.

Didn't you get the lesson that FDR made the depression worse with the New Deal? Morganthau, his treasury sec admitted as much. WWII pulled us out of depression, but things didn't come back until 1953. Do you really want to go there again?

Actually, yours is such a tin-foil hat idea that I imagine this is a cunning plan to profit from the tsunami of litigation that would ensue. There won't be a tree left standing that hasn't been turned to foolscap. Way to go, destroy the system for personal profit!!

[Mark F. Dunkle, Esq. Dover, Delaware]

A Hawaii v. Midkiff type effort, grounded in the Supreme Court's blessing of government's use of the takings power to remedy widespread social and economic evils in a malfunctioning real estate market, in the present case the foreclosure and mortgage lending crisis, makes great sense. It would be interesting to see an economist's take on the idea. Unfortunately many of the State's have passed post-Kelo limitations on the use of eminent domain to address widespread economic problems that would likely preclude transfers of takings properties to private owners. Federal action seems most appropriate. ALI-ABA should pull together a proposal in this regard.