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.
This innovative approach to principal reduction, initially proposed by Cornell University law professor Robert C. Hockett, went mainstream recently when news broke that city officials in San Bernardino County were considering implementing the idea and after famed housing economist Robert Shiller promoted the proposal in a New York Times op-ed in late June. Shiller's piece argued that 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 argument stands, then any critique of the ideas merits or functions will be somewhat futile.
Consider first the theory of 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 actually better for investors than foreclosure. Shiller argues that 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 that any investors that don't write down principal are making the wrong business decision.
Consider further that principle 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; and
- 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 such an appealing solution to these problems. Reducing principal balances would lower household debt and reduce the number of underwater mortgages at the same time. This would mean fewer defaults and a faster clearing of the foreclosure pipeline while also boosting the spirits of homeowners.
But this is too simplistic of an understanding for how principal writedowns would work. Consider that the federal government's Home Affordable Modification Program has had re-default rates of over 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 gets a principal writedown recognizes that 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 owned 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 greedy bankers and overseas investors.
This does not matter though, because the idea that eminent domain is necessary for principal reduction rests on the idea that these investors are incapable of doing their own analysis because of the collective action problem. So pointing to the strong incentive that MBS investors have to get their analysis right and suggesting that 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 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 counter offer in court, or contest the condemnation in court. Very few people take the first option.
So 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 to stop the taking all together. Those prices would not be market established prices—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. But National Association of Real Estate Appraisers would certainly find a way to explain away this problem with campaign donations to existing county board members or city councilmen.
Professors Hockett and Shiller both have impressive resumes and are certainly world class thinkers making substantive contributions in the fields of jurisprudence and finance. However, this idea has exposed some naivete about the world of eminent domain. Unfortunately, this again is a secondary argument, relative to the philosophical framework's perspective on rule of law and property rights.
A relatively 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 that 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 Kelo v. New London (where the condemning authority argued that the economic benefit of taking private land to allow for a business development justified the use of eminent domain). Using this dangerous road of logic, anything that has the potential to boost economic growth would be cause for taking private property away from the hands of the citizenry.
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 second option to writedowns: the foreclosure process.
The third leg of the justified eminent domain use 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 the face value of the mortgage as a part of forcing the reduction of principal. 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 facevalue, given the likelihood of default, with its attendant costs."
The question becomes what really constitutes fair value? A standard free market view would be that fair market value is actually what someone will pay for a good or service, not what a judge determines as the worth of an underwater mortgage. And 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 the market is buying at (which is presumably the case, otherwise there would be no need for the eminent domain), then the government could buy at a price that it will be unable to later sell the mortgage for; 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 eminent domain to be legal?
Ultimately, Shiller is able to over look the potential for eminent domain abuse that violates property rights 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 that there is no way the investors caneffectively or efficiently respond to housing market problems because of constraints of collective action. Therefore, 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 intentional, subjective investment decisions made by banks, hedge funds, and institutional investors. Many of them could act, many of them choose not to. 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 the good of the few and rights trampled for a supposedly righteous cause.
Why not apply Shiller's logic to the environment? If coal pollutes the air 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 all coal mines and coal burning energy plants to preserve the air and use eminent domain for the good of the public. Sure some people would be hurt along the way, like coal miners, the town businesses that depend on coal miners, and citizens who have to pay more for energy. But we'd be better off. Shiller takes the same attitude of indifference towards MBS investors. And it is very poor reasoning.
At a certain level there is a measure of compassion in the mix for households beset by debt, needing to make medical payments or just buy healthier food. But if that is ultimately the source of support for this idea then don't call it a collective action problem, call it a human rights crisis (as some have done) or something similar. Then we can have a debate about the value of homeownership for families and the nature of debt as a prisoner. Those are topics for another column, but at least then we'd be talking about the same thing, instead of debating past each other.
For now, the reality is that sometimes write-downs are helpful, other times they are not. There is no universally accepted, objective, single course of action that the masses just have not seen. And that is the argument which should win the debate. The only collective action problem here is that the collective have not acted as Shiller would prefer.
Anthony Randazzo is the Director of Economic Research at the Reason Foundation. He can be reached at firstname.lastname@example.org. This is an updated version of a commentary that ran at RealClearMarkets on June 28, 2012.