For scores of cities across the nation, the housing bust is anything but over. Right now, over six years after home prices crashed, nearly 10 million homeowners, or about 20 percent of households with mortgages, continue to owe more on their home loans than their homes are now worth. Their homes are, in lending parlance, “underwater.”
Underwater homeowners, especially those who have lost jobs or full time work in a down market, find themselves stuck: they don’t have the money to make their mortgage payments, but neither can they sell their homes to repay their loans and relocate closer to new jobs. Countless families accordingly find themselves living in foreclosed homes; many are forced simply to walk away, leaving properties vacant.
At some point in many cities, the process begins feeding on itself. Entire neighborhoods can be caught in downward spirals as property prices plummet, tax bases dwindle—ironically, just as foreclosed property abatement costs rise—and essential city services are cut, further diminishing property values. Cities nationwide find themselves blighted and bankrupt.
Richmond, California, made the news recently because it plans to be the first city to use its power of eminent domain to address this crisis. The plan is simple: the city would use its eminent domain authority to purchase underwater loans at fair market value, then write down the loans to bring homeowners above water. Potentially, Richmond could turn around thousands of properties, and in the process save entire neighborhoods from ruin.
Many other cities beside Richmond are now considering this path as well. Irvington, New Jersey, for example, resolved in July that the eminent domain plan “must” be employed. Other cities have commissioned cost-benefit analyses of the eminent domain approach to their foreclosure crises, while others are just beginning to investigate the approach’s potential.
The plan to use eminent domain to save neighborhoods and cities was conceived by Century Foundation fellow Robert C. Hockett and a few others at the time of the housing price crash back in 2007–2008, as a means of getting past dysfunctional contractual and other structural impediments to voluntary creditor- and debtor-friendly modifications of securitized loans. Two recent publications in particular, one in the Stanford Journal of Law, Business, and Finance in 2012 and another earlier this summer in the Federal Reserve Bank of New York’s Current Issues in Economics and Finance, seem to have helped jumpstart much public discussion of the approach. I had a chance to ask him some questions about his plan, and how it might be used.
1. The popular image of eminent domain is often that of big, bad cities beating up on the little guy to take their properties to build a road, a shopping center, or a sports arena. How did you get the idea to use it instead to protect families so that they could keep their homes?
It was actually quite simple. Shortly after the housing price crash, a few of us with an interest in housing and home finance noticed that underwater portfolio loans, held by financial institutions with authority to modify them, modified at significant rates. This was easily explained because underwater loans are subject to high default risk (not to mention high potential foreclosure costs), meaning that their expected values, post-crash, could be significantly raised by writing them down. Write-downs in such cases are “win-win”—they are creditor- and debtor-friendly alike. Securitized loans, by contrast, were not being modified at these rates, even though the same financial logic applied to them. It quickly became apparent that one of the main culprits (I’ll mention more below) was the contracts pursuant to which these loans were securitized—drafted in haste during the bubble years when many thought home prices “can only go up”—did not provide for post-bust modifications on the requisite scale. Eminent domain is the legal tool we have at our disposal to remedy those now dysfunctional contracts, which effectively function as suicide pacts among bondholders and homeowners.
2. Do you know how many cities have expressed interest in this plan? How many homes might be rescued this way?
Upwards of two dozen cities (and still counting) are now at various stages of adopting or considering the plan. Richmond, which you noted, has already made offers on its first batch of loans. Depending on how the servicers and trustees reply to those offers, the city might commence eminent domain proceedings this very month. Irvington, New Jersey has already resolved to move forward, and will presumably be considering various versions of the plan soon with a view to selecting—or perhaps designing—an optimal version well adapted to the particulars of its own foreclosure crisis. Other cities have contracted with me and with associates of mine to conduct studies of their foreclosure profiles or cost-benefit analyses of prospective versions of the eminent domain plan. These cities, it bears noting, are located in all regions of the country—northeast, southeast, northwest, southwest, and Midwest—and each will decide for itself precisely what version, if any, of the eminent domain plan to adopt. A nice feature of this approach is its adaptability to differing local conditions and preferences. A related point is that I am working with multiple nonprofit, for-profit, and community groups alike to develop or fine-tune varying “flavors” of the plan. Cities that move on this idea will have many potential plans, and multiple competing potential providers, from which to choose. And they will have the option of designing their own plans.
3. What are the basic criteria identifying situations and properties where a city should consider using eminent domain this way? Are there instances where cities should not pursue this plan?
I think there are two basic criteria. First, the loan should be sufficiently well underwater that modifying it will actually improve its expected value. That renders the write-down “win-win”—good for creditor and debtor alike. Second, the presence of structural impediments—that is, dysfunctional securitization contracts as noted above, creditor collective action problems, conflicts of interest between first and second lien holders, dysfunctional compensation arrangements that lead loan servicers to prefer foreclosures even to simultaneously creditor- and debtor-friendly workouts—that are blocking voluntary win-win modifications. That will make clear that market failure is preventing the win-win transactions from occurring, justifying resort to the eminent domain tool in the interest of all. Absent these two criteria, I think the case for eminent domain use is a bit more difficult to make, though perhaps less so where predatory lending or foreclosure-related blight—as, for example, in Detroit—have been pronounced.
4. It is estimated that the “negative equity” held by underwater homeowners is about half a trillion dollars. That is a lot of money. Writing down even a small portion of it is going to ruffle some feathers. Who is likely to come out against this plan?
As noted above, ultimate creditors should be as happy as homeowners with the plan. The half trillion dollars in negative equity occasions enormous “deadweight loss” rooted in contract rigidities, collective action problems, conflicts of interest, and other market failures. Recouping that loss is accordingly adding value, value that can be Solomonically distributed among all direct stakeholders. Opponents of the plan, therefore, are likely to fall into one of three categories. First, some elements of the securitization industry are apt to oppose the idea because it is premised on the dysfunctional nature of the securitization arrangements they put together during the housing price bubble. Actual success by the plan will tend to highlight the harmful role played by those securitizations. Second, some people who have legitimate concerns about past abuses of eminent domain—as in, for example, the Supreme Court’s lamentable Kelo decision of 2005, in which eminent domain was used to remove people from their homes rather than keep them in them—will be vulnerable to misinformation campaigns suggesting that the plan is to take their homes, rather than the loans, or is to “rob” bondholders in order to “bail out” homeowners. I actually have flyers that industry groups placed in people’s mailboxes in some cities in apparent “robo-calling” and “robo-mailing” campaigns prior to city council votes on the eminent domain plan, stating such falsehoods as those. Finally, third, some people who do not realize that eminent domain always has applied to all forms of property, tangible and intangible alike, might fear the plan to amount to a “radical extension” of eminent domain authority which places us on a “slippery slope.” People with that misconception and attendant worry will be particularly vulnerable to misinformation campaigns of the kind mentioned above.
5. Any good plan has to have a little something for everyone. Who are the key stakeholders, and what might this plan give each of them?
Great question. Hopefully I’ve afforded some indication of the stakeholders and how they stand to benefit in the foregoing. In essence, they boil down to three: the creditors, the debtors, and their communities. The plan benefits all three. The creditors, by enabling them to enjoy the same value-recoupment that portfolio loan holders enjoy when they modify deeply underwater loans. The debtors, by replacing unsustainable underwater debt with sustainable above-water debt and continued secure homeownership. And their communities, by reversing precisely that downward spiral you mentioned in opening this discussion above.