And now for another terrible housing idea: using eminent domain to “condemn” underwater mortgages, forcibly buy them from mortgage-backed securities (MBS) investors at rates below face value, then sell the new mortgages with lowered principal balances to other private investors.
As terrible as this idea is, the debate cannot focus on just the problematic nature of reducing principal for some families, or on the complexities of eminent domain. That would miss the larger, philosophical statement being made by this idea’s supporters—it is on the underlying framework of thought that the debate should focus.
Collective Action View
This innovative approach to principal reduction, initially proposed by Cornell University law professor Robert C. Hockett, recently went mainstream when famed economist Robert Shiller promoted the plan in a New York Times op-ed. Shiller’s piece argued the housing debacle has been caused by a collective action problem and if municipal officials were to just leverage their eminent domain authority, they could clean up the housing mess and ride off into the sunset as heroes.
This collective action view is the philosophical underpinning of the idea to use eminent domain to write down mortgage principal. As long as this principle is accepted, any critique of the idea’s merits or functions will be somewhat futile.
Consider first the theory behind reducing the principal balance for homeowners whose homes have fallen in price below the mortgage they took out to buy the house.
There is still a substantial debate over whether writedowns are better for investors than foreclosure. Shiller argues it is “well known” that lenders lose more in foreclosures because of legal costs and having to sell the home in a depressed market, tacitly claiming any investors who don’t write down principal are making the wrong business decision.
Consider further that principal writedowns can seem like a silver bullet for solving the housing mess. For the most part, there is widespread agreement on what the problem in the housing market is:
- Household debt remains at unsustainably high levels, making a housing market recovery impossible, and in turn weakening consumption, which has created a trickle-down effect throughout the economy.
- Underwater mortgages remain a persistent problem, creating unstable household financing, making it difficult for families to sell their homes, which has led to increasing default rates.
- These challenges exacerbate an already clogged foreclosure pipeline that still has to wrestle through millions of homes left in the shadow inventory.
- Collectively, households are left in a pessimistic state, needing to readjust their expectations for housing values and future wealth growth.
I call these the Four Horsemen of the Housingocalypse. They have thus far laid waste to a once-thriving housing market and will continue to march back and forth across America for the next several years.
It doesn’t take a genius to see how principal writedowns are an appealing solution to these problems. Reducing principal balances would lower household debt and reduce the number of underwater mortgages. This would mean fewer defaults and a faster clearing of the foreclosure pipeline while also boosting homeowners’ spirits.
Reasons for Reluctance
But this is too simplistic an understanding of how principal writedowns would work. The federal government’s Home Affordable Modification Program has had re-default rates of more than 50 percent. Sometimes a family that is in a home worth less than the face value of their mortgage won’t be able to make payments even if the principal balance is reduced. Sometimes a family that receives a principal writedown recognizes they still have no equity in the home and can walk away just as before. Sometimes lenders can get more money for their shareholders or investors by taking a home into foreclosure and selling it, rather than taking a loss by offering to reduce the principal balance owed by the borrower.
So in contrast to Shiller’s view, many MBS investors have expressly refused to modify loans because their analysis shows there is more financial upside to foreclosures than principal reduction. They have clients and shareholders to protect, many of whom are teachers, firefighters, and grandparents, not just bankers and overseas investors.
This does not matter, though, because the idea that eminent domain is necessary for principal reduction rests on the belief that these investors are incapable of doing their own analysis because of the collective action problem. Pointing to the strong incentive that MBS investors have to get their analysis right and suggesting the just course of action is to allow investors to make their own choices, whether they turn out profitable or not, is an argument that falls flat at the walls of the Hockett/Shiller philosophical framework.
The second element of the Hockett/Shiller argument is that eminent domain would be an effective way to pursue principal reduction. This is where academia runs into the usual trap of devilish details. Using eminent domain to “condemn” mortgages would create a highly complex legal nightmare worse than the foreclosure mess, and would take years, if not decades, to process through the court system.
In a traditional case of a county wanting to build a highway through a farmer’s field, the landowner can either accept the offer from the county to buy his land, get a friendlier appraisal and counteroffer in court, or contest the condemnation in court. Few people take the first option.
The courts would be dealing with hundreds of thousands of cases with mortgage investors fighting for government officials to give them a better price or stop the taking altogether. Those prices would not be market-established—i.e., an actual buyer saying he would buy the reduced mortgage at the lower-than-face-value price—and would not be guaranteed to be sold back to investors, creating liabilities for the municipal government engaging in the abusive use of eminent domain.
A mainstream view of eminent domain is that it is justified only if the governing body is taking private property for necessary public use, with no alternative courses of action, and full compensation is granted.
Using eminent domain to take mortgages may not satisfy any of these criteria. Shiller might argue writing down mortgages would ultimately help the economy as a whole and provide a public good, but this is the same logic that was applied in the Supreme Court’s Kelo v. New London ruling (where the condemning authority argued the economic benefit of taking private land for a business development justified the use of eminent domain). Using this dangerous logic, anything that has the potential to boost economic growth would be cause for taking private property away from citizens.
The second criteria is that there are no alternative courses of action, but obviously that is not the case, as the MBS investors have suggested a clear alternative to writedowns: the foreclosure process.
The third leg of the eminent domain stool is fair compensation. This is particularly important because the mortgages to be seized would explicitly be taken with the intention of paying the investor less than face value. As Shiller writes in his New York Times piece, “Governments could seize underwater mortgages, paying investors fair market value for them. . . . The true fair market value for these mortgages is arguably far below their face value, given the likelihood of default, with its attendant costs.”
Question of Value
The question becomes what really constitutes fair value. A standard free market view would be that fair market value is what someone will pay for a good or service, not what a judge determines the worth of an underwater mortgage to be. This could create complications for a condemning authority trying to figure out how to price the underwater mortgage.
Consider that if the price the investor would demand to sell the mortgage is not what buyers want to pay (which is presumably the case, otherwise there would be no need for eminent domain), the government could be unable to sell the mortgage afterward, thus creating financial liabilities for taxpayers. On the other hand, if the government forced the investor to sell at a lower price than desired, has the investor truly been compensated justly to meet the criteria for use of eminent domain to be legal?
Ultimately, Shiller is able to overlook the potential for eminent domain abuse and misconstrues fair value because he is looking at the housing mess as a collective action problem.
“At the moment, the trouble in our real estate markets and the drag these markets are placing on our entire economy may be understood as a collective action problem,” Shiller wrote as the foundation for his argument. “In the current real estate market, the relevant group is enormous and complex. . . . These people live all over the world and have no way of communicating with each other, let alone coming to an agreement to give homeowners a break.”
Shiller’s view is there is no way the investors can effectively or efficiently respond to housing market problems because of constraints of collective action. Therefore, we are to ignore the problems of this proposal as argumentative nitpicks and focus on the short-term picture.
Today’s housing troubles are not a collective action problem, though.
The reason so many homes remain underwater is because of investment decisions made by banks, hedge funds, and institutional investors. Just because the investment choice is undesirable doesn’t mean investors are incapable of doing their own analysis. It is certainly likely that some principal has not been written down because of paperwork backlogs, poorly trained customer service reps, incompetent managers, and other unfortunate problems. But this is not cause for Shiller to make a utilitarian argument that what is good for the whole should be valued over rights that would be trampled.
Why not apply Shiller’s logic to the environment? If coal pollutes and it is taking a long time for renewable energy products to develop because coal-fired power is still so cheap, then the same logic suggests the government should seize and close all coal mines and coal-burning energy plants for the good of the public. Sure, some people would be hurt along the way, such as coal miners, businesses that depend on coal miners, and citizens who have to pay more for energy.
Shiller takes the same attitude of indifference toward MBS investors. And it is poor reasoning.
The reality is that sometimes writedowns are helpful, other times they are not. There is no universally accepted, objective, single course of action the masses just have not seen. And that is the argument that should win the debate. The only collective action problem here is that the collective has not acted as Shiller would prefer.
Anthony Randazzo ([email protected]) is director of economic research at Reason Foundation. Used with permission from Reason.org, where a version of this article first appeared.