A proposal to use eminent domain to ward off foreclosures in two cities in San Bernardino County has been slammed almost unanimously by both Wall Street and federal regulators. The most powerful dissenter was Edward J. DeMarco, acting director of the Federal Housing Finance Agency, who said on August 7 that he would resist any effort by local governments to "take" homes owned by Fannie Mae and Freddie Mac, the two agencies under his supervision; those agencies buy the majority of US home loans and repackage them as mortgage-backed securities. Coupled with an earlier rejection by the same official to reduce the unpaid balances on "underwater" mortgages, few options appear available to homeowners sliding into foreclosure, except to deed the properties back to the lender.
With an estimated 13.5 million American households underwater on their mortgages – that is, owing more on their mortgages than the market values of their homes – foreclosure remains the greatest single barrier to the recovery of the housing market –and arguably to the economy itself. Homes that are "underwater" are perceived to be right at risk of foreclosure, particularly for home owners who view their mortgage payments as "throwing good money after bad," to quote a neighbor of mine who just went through the process. The lukewarm response of the Obama administration to the foreclosure crisis is one the shortcomings of the president's first term.
In inland California, the housing crisis has hit families and cities alike. The bankruptcies of cities like Stockton and San Bernardino are due in no small part to the plunge in home values and even the abandonment of otherwise perfectly good homes. It's hard to collect taxes when your populace has fled for someplace they can afford.
At the national level, the administration's most effective response, to date, is the HARP 2.0 loan, a government-backed loan program able to refinance mortgages for more than 100 percent of the mortgage balance. (Otherwise, home owners who are underwater can't refinance.) Introduced in October 2011, the program represents nearly one in four re-financings currently, according to the Mortgage Banking Association. (Limiting the program's effectiveness, however, is a requirement that home owners be current on their mortgage payments for 12 months; that limitation, while prudent from the lender's perspective, leaves millions of at-risk home owners without the means to refinance their home loans to affordable levels.)
If impolitic, the idea of using eminent domain is an ingenious response to a genuine crisis: the destructive effect of foreclosure on cities and neighborhoods. Mass foreclosure is the broken window syndrome in block-high letters: Empty houses become playgrounds for antisocial activity and for squatters; the same neighborhoods are shunned by families and investors. In the hardest hit cities, such as working class neighborhoods in Cleveland, entire blocks have been emptied as a result of falling home values and the inability of many home owners to refinance. Property values implode, and neighborhoods become dilapidated slums for decades.
It's not surprising that San Bernardino County, along with the City of Fontana in the same county, might look at eminent domain as a way to stanch the bleeding. The concept has been devised by a San Francisco firm, Mortgage Resolution Partners. Here's how it works: The city identifies homes that are underwater. With the cooperation of the home owner, the city condemns the property, takes possession, and then transfers ownership to the investor. The investor, in turn, creates a new mortgage for the home owner with a lower balance and lower monthly payments. The investor gets $4,500 per successful turnover. The winners are the home owner, local government and the investor. The loser is Wall Street, Fannie Mae, Freddie Mac and the bond holders who own mortgage-backed securities.
Legal and even constitutional questions abound. Defenders of the take-the-foreclosures proposal say that eminent domain exists to advance public purposes. What could be more public than preventing mass foreclosure and neighborhood degradation? Opponents point out, however, that mortgages are not real property, and that mortgages have never before been "taken" by government. Moreover—and this is a powerful argument –government intrusion into a contract between two private entities—here, the lender and the home owner—could potentially violate the contract clause of the Constitution.
Further, the ability to "take" properties from their owners, which are most often Fannie Mae, Freddie Mac or giant, private buyers like GMAC, could have a harmful impact on the way that mortgage finance works in the US. The majority of lenders sell their mortgages to second-market agencies like Fannie Mae for cash; the lender's replenished funds are then used to finance new loans. While many left-leaning observers may understandably look askance at this system—mortgage-backed securities, after all, were at the center of the financial meltdown of 2008—it probably does not make sense to compromise the integrity of the bonds, by saying that local governments can forcibly take possession of properties when markets go south.
Why would local governments, then, embrace eminent domain in the first place? My assumption is that government could identify the homes in greatest danger, while policing the investor who buys the loan. The obvious error is to introduce eminent domain into the agreement, which is unnecessary. One could imagine a somewhat similar arrangement, in which the city and the bond investor form a private, not-for-profit corporation that buys a home from a willing seller as a short sale; again, the city is the guardian of both public policy and the home owner, while the investor puts up the money. After the short sale is completed, the investor provides a new mortgage with a reduced balance to the home owner, and pockets his fee. In this scenario, nobody's ox is gored, at least theoretically.
Even better is a proposal from Sen. Jeff Merkley (D-Oregon) who has proposed a large-scale refinancing scheme called Rebuilding American Homeownership. (The proposal was praised in a recent New York Times editorial by economists Joseph Stiglitz and Mark Zandi. (http://www.nytimes.com/2012/08/13/opinion/the-one-housing-solution-left-mass-mortgage-refinancing.html?_r=1rat)
Under the Merkley proposal, home owners who are current on their mortgage payments could refinance at extremely low rates, perhaps 2 percent higher than the Treasury rate, the super-low rate that the government uses for borrowing. The trust making the super-low-interest refinance would accept refinance applications for three years, then "wind down," according to Stiglitz and Zandi. In other words, if buyers cannot get lenders to lower their balances, perhaps the government can make interest rates affordable. Again, this solution offers little for people in financial trouble. Still, this seems like an orderly process in which no oxen are harmed – even though the authors speculate that some lenders may complain about losing the income from performing loans with high interest rates. The next question is whether a rational proposal that assists millions of home owners and helps revive the economy, has a chance in an election year--or with an opposition determined to defeat any proposal by the current administration.