Michael Meeropol: A Creative Way To Force a Principal Write-Down of Underwater Homeowners' Mortgages

Aug 2, 2013

Six years ago I noted in a commentary that there was a very simple solution to the foreclosure crisis that followed the bursting of the housing bubble.  The solution is to force any financial institution that foreclosed on a property to permit the current homeowners to stay in the house as renters with the rent fixed at a current market rate.  A version of this idea was introduced in Congress in 2010.

(For details see Dean Baker “The Right to Rent Plan” Center for Economic Policy Research Issue Brief. http://www.cepr.net/documents/publications/right-to-rent-2009-07.pdf.  The current version of the proposed law is now in Congressional limbo – assigned to committee but with no hearings scheduled.  See http://www.govtrack.us/congress/bills/112/hr1548/text.  The “Right to Rent Act of 2013” was introduced in Congress on June 28, 2013.)

If this were enacted it would slow if not eliminate the spread of urban blight from abandoned homes and would force the financial institutions that caused the housing bubble in the first place to shoulder some of the costs of its deflation.

The New York Times of July 30 highlighted another creative solution to the problem – one that is about to be used in Richmond California. 

[See Shaila Dewan, “A City Invokes Seizure Laws to Save Homes.”  New York Times, July 30, 2013, A1-B2]

Richmond plans to offer to buy the mortgages on homes that are worth much less than the homeowners owe.  They will pay a fair market value – much lower than the inflated original price.  The homeowners will then re-finance – allowing them to remain in their homes and removing the onerous payments required by the mortgages they took out during the housing bubble.

The article notes that the initial offers on 626 loans does not include large second mortgages – This is to avoid the charge that the city is rewarding people who irresponsibly used these second mortgages to treat their home as an ATM machine (a charge that was true of some people during the rapid increases in home values over the course of the housing bubble).

The policy innovation is that IF the mortgage owners refuse to sell at these reasonable prices the city plans to use eminent domain to seize the houses at a fair market price.

The idea of eminent domain is that seizure of property is permitted even if the owner doesn’t want to sell if the property is needed “to promote the public good.”  Clearly, the avoidance of blight in neighborhoods and keeping communities intact are “public goods.”   Unlike the use of eminent domain in the Rhode Island case where property was taken so a developer could make millions, this use of eminent domain will help ordinary homeowners by reducing their monthly housing costs and forcing lending institutions to bear the burden of reduced income.

Needless to say, the banks and real estate industry are mobilizing everything they’ve got to prevent this from happening.  A member of Congress, doing their bidding, has introduced a bill that forbids Fannie Mae, Freddie Mac or the FHA from making, guaranteeing or insuring any mortgage in any community that uses eminent domain to obtain these properties.

This would of course make the refinancing part of the process impossible for most homeowners.  Since that law has no chance of passing, the fat cats focusing on public opinion and other scare tactics.  They are mounting a strenuous lobbying campaign and threatening lawsuits to tie up any city that tries to use eminent domain.

One mailer circulated in North Las Vegas (an area with lots of underwater homeowners) accused the private firm contracted to manage the Richmond program of “hatch[ing] a plan to make millions of dollars by foreclosing on homeowners who are current on their payments.” (NY Times, 7/30/13 B2)  This is completely false, of course.  It is true the management company will make profit from the activity --- but homeowners who owe more on their house than it is worth (even those current on payments) will see their payments reduced from the re-financed mortgage they will be offered by the city.  They will not be foreclosed on.

In a situation such as the present, where many homeowners are under water (the term for owing more than a home is worth)  principal write-downs are actually the best method of preserving value in homes.   It avoids the costs of foreclosure and the collateral damage to neighborhoods.  Congress twice considered a law giving bankruptcy courts the power to “cram down” the value of existing mortgages to more accurately reflect the value of homes but those efforts failed.  Only about 1 percent of all underwater mortgages have been written down since 2007.   For details see the interesting article by Cornell University Law Professor Robert Hockett, “Paying Paul And Robbing no One:  An Eminent Domain Solution for Underwater Mortgage Debt”  http://www.newyorkfed.org/research/current_issues/ci19-5.pdf

Because the banking and real estate industry is so opposed to these ideas, it is important to recall what caused the housing bubble in the first place.  The Times article mentioned that “Many of the communities considering eminent domain were targeted by lenders who steered minority families eligible for conventional mortgages into loans with higher interest rates and ballooning payments.” (P. B2)  Among cities considering following Richmond’s lead are Irvington, NJ, Law Vegas, NV, and El Conte, CA.  Unfortunately, San Bernardino County in California was scared off by the threat of a lawsuit.

The housing bubble was fueled not just by general “irrational exuberance” but by predatory lending practices.  The mortgage market changed from one where banks would issue mortgages and hold them to maturity to one where banks and other institutions would originate the loans, slicing and dicing them into packages, and then sell them off after collecting the fees.  Instead of “lend and hold” the mortgage market became one of “originate and sell.”  These packages combined many low quality loans which “convinced” the rating agencies that the new bundles deserved triple A ratings.   Allegedly this was because of the so-called “law of large numbers” – the larger the number of instruments in a bundle, the less likelihood would there be that the “bad apples” in the bundle would corrupt the entire “barrel.”  Of course we now know that the rating agencies were bought off and didn’t really do any “due diligence” on those new-fangled instruments.  With 20-20 hindsight it’s amazing that any of these fancy bundles of low quality loans could have been combined into Triple A instruments.

Richmond and every other entity that tries this creative solution deserve our wholehearted support.  Let’s finally make the financial industry pay for at least some of the damage they did before the 2008 crash.  Let’s bail out homeowners for a change.

Michael Meeropol is visiting professor of Economics at John Jay College of Criminal Justice of the City University of New York. He is the author of Surrender, How the Clinton Administration Completed the Reagan Revolution.

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