fed report on eminent domain

7/28/2019 Fed report on eminent domain

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Volume19,Number52

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Paying Paul and Robbing No One:

An Eminent Domain Solution forUnderwater Mortgage Debt

Robert Hockett

In the view o many analysts, the best way to assist

underwater homeownersthose who owe more on their

mortgages than their houses are worthis to reduce the

principal on their home loans. Yet in the case o privately

securitized mortgages, such write-downs are almost impossibleto carry out, since loan modications on the scale necessitated

by the housing market crash would require collective action

by a multitude o geographically dispersed security holders.

Te solution, this study suggests, is or state and municipal

governments to use their eminent domain powers to buy up and

restructure underwater mortgages, thereby sidestepping the need

to coordinate action across large numbers o security holders.

It is now more than six years since U.S. residential real estate prices peaked and

then plunged. Prices dropped nationally by 35 percent and still linger close to30 percent below peak levels. In harder-hit communities, prices are considerablymore than 50 percent below peak.1 While cyclical uctuations push prices up or brieperiods, no consistent upward trend has been rmly established (Chart 1). Indeed,the highest post-bubble price peak prior to March 2013 came not last year or theyear beore but in July 2010, while early 2012 saw the deepest post-bubble troughsince April 2009. Prices reached a seasonal peak in September 2012, then leveled othrough February 2013. Tese uctuations, highlighted in the moving average changemeasure in Chart 1, have been the pattern in home prices since 2009.

While home pricesand hence home equity valueshave allen and remainlow, the xed debt obligations that buyers had to take on to purchase homesunder bubble conditions have not. Consequently, approximately 11 million

homes, or slightly less than a quarter o all homes with mortgages outstanding,are underwatermeaning that the balance on the mortgage exceeds thecurrent market value o the home. O these mortgages, between 3 million and4 million are in deault, in oreclosure, or oreclosed and awaiting liquidation.Over 2 million more are seriously delinquenttwo-to-our payments in arrears(Olick 2012; Goodman et al. 2012; Ritholtz 2012; Goodman 2012).

1 Data are rom CoreLogic, available at http://www.corelogic.com/, and rom OCC Mortgage Metrics,available at http://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/index-mortgage-metrics.html.


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CURRENT ISSUES IN ECONOMICS AND FINANCEVolume 19, Number 5

Recognizing that deaults and oreclosures take a toll on theeconomic welare o communities and the nation as a whole,many analysts have called or the write-down o principal onmortgage debt as the most eective solution to the problem ounderwater mortgages. As these analysts attest, write-downshave the important advantage oraisingvalue.

However, the diculty lies in carrying out the write-downs.While principal reduction on mortgages held in bank portoliosoccurs at signicant and still growing rates, loans held in

private-label securitization (PLS) trusts have certain structuraleatures that make such reductions very rare. Specically, theseloans are subject to pooling and servicing agreements thatwould require collective action by a large majority o securityholders beore the loans could be modied or sold out o trusts.Conducting such a collective action across most holders o thesecuritized loans would be nearly impossible.

Tis edition oCurrent Issues puts orward a strategy orcarrying out the write-downs. Essentially, it recommends thatstate and municipal governments use their eminent domainpowers to address the collective action problems that nowprevent the write-down o privately securitized loans. Undereminent domain, these governments can step in to purchaseunderwater loans at air value, deal directly with the trusteeso the private-label securitization trusts, and sidestep therigidities o the pooling and servicing agreements. Tey canthen reduce the principal on these loans, lowering the waterand thereby reducing the risk o deault.

Te Mortgage Debt Overhang: Scope o the ProblemFewer than hal o the nations roughly 11 million underwatermortgages are current, and large numbers o these mortgages

go delinquent each month:2 ogether with loans that arealready delinquent or in deault, 7.5 to 9.5 million additionalhomes are expected to go into liquidation over the next severalyears absent remedial action.3 Tese liquidations would urtherburden an already depressed market, yielding a backlog ovacant homes equal to 200percent o U.S. annual home salesat the current sales pace (Olick 2012; Goodman et al. 2012;Ritholtz 2012; Goodman 2012).

For communities, the allout rom these developments issubstantial, with residents orced to give up their homes andproperty tax bases weakenedironically, just as abatementcosts wrought by abandoned properties rise (Hockett 2012a).Other homeowners lose neighbors and endure the blight andlost value associated with boarded-up neighboring homes.Over time, they may see city services cut, school districtsretrenching, and local economies shrinkingan aggregatemonetized loss now estimated at $2 trillion (Hockett 2012a;

Shoen 2012). Tough causality is doubtless complex, the actthat so many counties have been ling or bankruptcy o lateseems unsurprising against this backdrop (Church et al. 2012).

Te mortgage debt overhang undermines the health o thenational economy as well. Deaults and oreclosures in thehousing markets eed back into the macroeconomy througheects upon net worth and spending (Federal Reserve Board2012; Dudley 2012). And as reduced spending lowers growthand employment, more mortgages are drawn into oreclosure(Federal Reserve Board 2012; Dudley 2012; Hockett 2012a,2012b). Hence the amiliar holding pattern o high under-water loan and oreclosure rates yielding low growth and

employment, which in turn yield yet more deault and ore-closure, and so on (Hockett 2012a, 2012b, 2013).4

Te Prudent Solution: Scaled Principal Write-DownsTe most eective means o averting mortgage delinquency,deault, and oreclosureand the associated economiccostsis principal reduction. As even creditors recognize,

2 See Olick 2012, Goodman et al. 2012, Ritholtz 2012, and Goodman 2012,as well as the latest data rom CoreLogic and OCC Mortgage Metrics, citedin note 1 above.

3 See, or example, Fannie Mae 2012 Form 10-Q data, p. 111, available athttp://www.anniemae.com/resources/le/ir/pd/quarterly-annual-results/

2012/q22012.pd. See also Olick 2012; Goodman et al. 2012; Ritholtz 2012;Goodman 2012.

4 O course not all mortgage troubles are attributable to declining home values.Some homeowners ace diculty keeping current on payments or reasons otemporary unemployment in a slack economy. For this class o mortgagor, severalcolleagues at the Federal Reserve Bank o New York and I have designed a HomeMortgage Bridge Loan Assistance Program, inormed by a successul Pennsylvaniaprogram developed during the early 1980s steel slump (Orr et al. 2011). A drabill to institute the program, which two o us coauthored, is under consideration inNew York (Campbell and Hockett 2012a, 2012c). But even assuming success hereand in other states, the nations larger mortgage debt overhang problem will remainunaddressed (Campbell and Hockett 2012a, 2012b).

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125

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2253-month moving averagechange in HPI

20-city composite HPI

2012201120102009200820072006

Source: Standard & Poors/Case-Shiller Home Price Index (HPI).

Percent

Trends in Home Prices: July 2006March 2013

Based on the Twenty-City Composite Case-Shiller Home Price Index

Case-Shiller HPI

Scale

Scale


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debtloss must be ormally recognized in a manner that bearssome intelligible relation to home equity loss. Moreover, ormuch underwater mortgage debt, write-downs raise valueabenet borne out by the requency with which portolio loanholders write down debt (Olick 2012; Goodman et al. 2012;Ritholtz2012; Goodman 2012).

Write-downs are not easily carried out in all cases, however.Much depends on whether the targeted loans are held in bankportolios or by private-label securitization trusts. In the port-olio case, write-downs occur at signicant and still growingrates (Goodman et al. 2012; Goodman 2012; Streiteld 2011).Bank ocers know that underwater loans oreclose at highrates, with the result that expected values all needlessly shorto ace values; hence, they nd it nancially rational to writedown these loans. In so doing, they benet not only them-selves, but also their debtors and the communities in whichthey reside. In this case, the interests o all parties converge.

Securitized mortgage loans, however, pose a problem.While it would be no less rational or benecial to write theseloans down, certain structural eatures o the loanseaturesthat now act as market ailuresprevent the rational thingrom being done. Te upshot is deadweight lossloss whoserecoupment and equitable distribution is one object o theplan sketched below.

Structural Impediments to Write-DownsWhat are these structural impediments? A host o classiccollective action problems, reinorced by dysunctionalcontract provisions, stand in the way o the optimal solution

(Hockett 2012a, 2012b; Shiller 2012). For one thing, there isa last-mover advantage where write-downs are concerned,owing to the benets (positive externalities) that accrue tothe creditors on later loans when principal is reduced onearlier loans. Tis problem aficts portolio loans too, ocourse, and probably thereore keeps modication rates lowerthan optimal even among banks. But in the case o privatelysecuritized loans, it is reinorced by additional challenges.

Most decisive among the additional challenges is that somany o the pooling and servicing agreements governing theprivate securitization o loansagreements draed during thebubble years when ew oresaw a marketwide housing price bust,

and many rushed either to push or to purchase an innovativeproductrequire supermajority voting among mortgage-backedsecurities (MBS) holders beore loans can be modied or soldout o trusts. And these bondholders, geographically dispersedand unknown to one another, cannot collectively bargain withborrowers or buyers on workouts or prices.

Moreover, the agreements governing the loans preventtrustees and loan servicers, who are duty-bound to act onbehal o the bondholders and thus could in theory address

their collective action problems, rom modiying or sellingo loans in the requisite numbers (Hockett 2012a, 2012b).5Finally, the agreements typically stipulate compensationarrangements that make it more protable or servicers tooversee lengthy oreclosure proceedings than to seek modica-tion.In sum, then, these contracts now virtually ensure thatmortgage loans will deault, harming all interested parties.

Additional complications arise rom the act that manyunderwater homes are subject to second liens that secure homeequity lines o credit or closed-end second mortgages. Firstlienholders benet little rom loan modications unless secondlienholders modiy too; hence, they are rationally reluctant tomodiy on their own. But second lienholders eel less pressureto modiy because borrowers, strapped by post-bust liquidityneeds or which home equity lines constitute precious sourceso credit, are apt to make payments on them rsta reversalo the legal order o creditor priorities (Goodman 2012).6 Inaddition, the second lienholders quite oen are banksthe

same banks that service the rst-lien-secured loans. Tatposes a conict o interest where rsts preer that secondsmodiy too in order to optimize the benets that modica-tion brings to rsts, urther obstructing agreement amongborrowers and creditors.

Other constraintsincluding inapplicable bankruptcylaws and Internal Revenue Code and rust Indenture Actuncertaintiesimpede the kind o collective action that wouldbenet both debtors and creditors (Hockett 2012a, 2012b). Butthe oregoing discussion suces to indicate how ormidablethe obstacles to principal write-downs can be, particularly orloans held in private-label securitization trusts.

Bypassing the Impediments through Collective AgencySolving a collective action problem requires a collective agent.O course, that is what PLS trustees and servicers in theory are.But as we have seen, these agents are oen hand-tied or con-icted. Who, then, will act or the creditors and, in so doing,or homeowners and spillover victims o local oreclosure andthe continuing weakness in the U.S. mortgage market?

As it happens, governments are also collective agents. Teyare likewise the sole entities authorized to sidestep the contractrigidities o the pooling and servicing agreements that stand inthe way o broad write-downs or PLS loans. But which govern-ment should take up this mantleederal, state, or local?

5 In some cases, or example, pooling and servicing agreements allow no morethan 5percent o the loans in the pool to be modied. Tispercentage, whichshows how little the marketwide crash was expected, has long since beenreached in the case o most loan pools.

6 Lee, Mayer, and racy (2012) oer a contrary view, nding that by the time aborrower goes delinquent on the rst lien, there is little credit available on thehome equity line.

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In 2008-09, this author and two others separately advocatedederal action under eminent domainthe power o govern-ments to take private property or public use (Hockett2009;Jackson 2008; Willis 2008). In 2010, two higher-proleadvocates, including one member o Congress, added theirnames to the call (Miller 2010; Kuttner 2010). But thus ar noaction o this sort has been taken, even though other actionshave brought some help.

Te ederal governments agship Home Aordable Mort-gage Program (HAMP), or example, has accomplished much,but it is not designed to deal with underwater or negativeequity mortgages. For their part, the government-sponsoredenterprises (GSEs) Fannie Mae and Freddie Mac have beensteered clear o write-downs by their regulator and currentconservator, the Federal Housing Finance Agency (Appelbaum2012). Finally, Congress has twice now attempted but ailed toget mortgaged homes into the Bankruptcy Code, thus leavingno means or bankruptcy judges to employ their equitable

powers to salvage value among mortgagors and mortgageesas they routinely do among other debtors and creditors.7

Te consequences o our ailure thus ar to ocus onprincipal reduction can be seen in more numbers: Since 2007,little more than 1 percent o underwater home loans have seenwrite-downs. Fewer than hal o these write-downs havebrought loans above water. Meanwhile, only 2.7 million loanshave been modied in any way by their servicers, while 40per-cent o these modications have reduced monthly payments byless than 10percent.8

Tis weak response is surprising in light o the abundantevidence, derived rom the portolio loan case, that sizablewrite-downs save sizable value (Olick 2012; Goodman et al.2012; Ritholtz 2012; Goodman 2012). And it is surprisingtoo given the compelling evidence, ound in the GSEs lingswith the Securities and Exchange Commission, that unmodi-ed underwater PLS loans will deault at high rates: For 2006vintage loans, or example, 71percent o subprimes, 70percento option adjustable-rate mortgages, 58percent o variable-rate loans, and a surprising 40percent o traditional xed-rateloans have deaulted.9

Te State/Municipal Eminent Domain PlanI it is not to be ederal instrumentalities or PLS trustees and

servicers, then, the collective agents best able to address thestructural problems that arise with the pooling and servicing

7 For more on the 2009 and 2010 eorts to pass mortgage cramdownlegislation, see Hockett (2012b).

8 See the latest CoreLogic data and OCC Mortgage Metrics, cited in note 1.

9 See Fannie Maes second-quarter 2012 Form 10-Q, p. 111, available athttp://www.anniemae.com/resources/le/ir/pd/quarterly-annual-results/2012/q22012.pd, and its 2011 Form 10-K data, available at http://www.anniemae.com/resources/le/ir/pd/quarterly-annual-results/2011/10k_2011.pd.

agreements on privately securitized loans are state andmunicipal governments. Tese governments (a) ace the brunto mass oreclosure and its consequences more directly thanthe ederal government in any event, and (b) have consti-tutional authority to address these exigencies.10 Let us rstconsider how the subederal units o government can act, thenelaborate briey on their suitability or these roles.

Using their traditional eminent domain powersa legalauthority enshrined in our state and ederal constitutionsor precisely such exigencies as the oreclosure crisispresentsstates or their sub-units can compulsorily purchaseunderwater loans rom private-label securitization trusts atair value, dealing directly with trustees and sidesteppingall contract rigidities. Tey can then write down theloans, reducing deault risk and raising expected valuesin the process.

I need be, eminent domain authority can also be used

to take second-lien-secured loans at air value, or eventhe liens that secure them, while leaving the notes withtheir holderseectively converting the latter to unsecuredconsumer debt. Tat prospect can bring recalcitrantsecond lienholders to the table with rstsparticularly i,as suggested below, they also are oered some raction othe surplus recouped through the write-downs.

Financing the Renancing: Federal Money,Private Money, or BothBut how are states or their sub-units to pay or the loans orthe liens, given that the oreclosure crisis has le them morecash-strapped than the ederal government? Here is how:One possibility is to nance the purchases with monies lentby ederal agencies in the manner o the reasurys roubledAsset Relie and Public-Private Investment Programs, andthe Federal Reserve Bank o New Yorks MBS stabiliza-tion programs, all o which ultimately have turned prots.Alternatively, they might use monies provided by private inves-tors, or monies rom both ederal agencies and private sources.Te ederal agencies or private investors then can be paid romthe proceeds o the renanced and accordingly more valuableloans, or in bonds issued against pools o the same.

I private money is used, then the investors both can andought to include current bondholders, who might receivewarrants beore ederal or private investors are brought in.Tis approach respects bondholder interests and underscoresthe sense in which the eminent domain plan is meant simplyto solve a collective action problem that dysunctional poolingand servicing agreements prevent trustees and servicers romsolving themselves on behal o their bondholder beneciaries.

10Note, however, that Fannie Mae and Freddie Mac themselves holdsignicant numbers o underwater loans in their portolios.


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By working with states or municipalities in this manner,current bondholders would piggyback on governmentalauthority to sidestep the contracts that currently precludetheir doing what portolio lenders already do. o note thatthese participating bondholders will be paying themselvesless than ace value would just be a roundabout way o sayingthat they are writing down principal.

Te diagram above presents a schematic rendering o

the eminent domain plan. Te diagram, which should beread counterclockwise, shows investors, including currentbondholders and perhaps ederal agencies, conveying undsto eminent domain trusts operated by the states or their sub-units. Tese eminent domain trusts then purchase deeplyunderwater (bad) loans rom private-label securitizationtrusts. Te states or their sub-units, in most cases probablyadvised or otherwise assisted by nancial proessionals, thenwork with homeowners to write new mortgages, replacingthe negative equity loans with modestly positive equityloansprobably thirty-year xed-rate mortgages in allcases.11 Finally, the new (good) loans are conveyed to therst-mentioned trusts, which convey the resultant unds to

the rst-mentioned investors.

Te payouts will in most cases take the orm that payouts onthe earlier, unmodied loans tookbond yields to bondholders.And, as noted earlier, the new bondholders should include asmany o the original bondholders as wish to participate, since

11Freeing the loans rom their PLS trusts, it bears noting, renders themamenable to the Federal Housing Administration Short Renance, HardestHit Funds, and HAMP Principal Reduction Alternative programs.

the aim o the plan is to enable homeowners and bondholdersto do what the pooling and servicing agreements now preventthem rom doingmodiying underwater loans to recouppresently lost value.

Te sequence o steps depicted in the diagram provides

only the broad outline o the plan. More is required torender any particular variation operational. Tere are, orexample, the matters o (a) selecting and valuing appropriateloans; (b) securing government and/or private investors,i any; (c) commencing the legal proceedings necessaryto exercise eminent domain authority; (d) modiyingand possibly re-securitizing the loans once purchased;(e) working with homeowners throughout the oregoing;and () compensating investors at appropriate stages.

All o these actions can be managed in various ways(Hockett 2012a). Briey, on (a), the guiding criterion shouldbe whether the loans expected value can be raised suciently

to oset the write-downs and associated transaction costs.A variation on this criterion, where public money is availableto supplement private money, might be to include loans whoseexpected-value improvements all slightly short o osettingthe write-downs and associated transaction costs, in light othe oreclosure externalities that write-downs will avoid.

On (b), i ederal and subederal units o government ndmerit in the plan, they can approach one another to arrangelending rom the ormer to the latter. Either can also approachexisting bondholders or other investors i desired.

On (c), states or their sub-units will commence the pro-

ceedings and courts will conduct them. In the quick takeproceedings available in most states, the taking authorityplaces the estimated value o the loans plus some margin inescrow when ling, explains the basis o its valuations to thecourts satisaction, then takes title. Subsequent litigation, iany, concerns only whether more should be paid, not whetherthe taking can proceed. In most cases, governments haveaccurately assessed the value o the loan, oen with assistancerom private valuation experts, and paid adequately. Tis bearsnoting in view o popular misconceptions concerning thelikelihood o protracted litigation.

It should also be noted that, in view o the market ailure

and consequent waste stories that prompt this proposal, wecan anticipate sizable pre-trial, out-o-court agreements amongstate or municipal governments and bondholders on loanselection and valuation criteria, particularly i relevant ederalocials acilitate.

As or (d), (e), and (), these are primarily matters orstates or municipalities to manage, albeit again with assis-tance rom public or private nancial proessionals in mostcases. he municipalities are best situated to approach

Investors:private and/or

public

Current MBSholders

Eminentdomain

trust

States/sub-units

Homeowners

$

$ $

$

PLStrusts

Overlapping membership

Good loans Bad loans

New obligation New lending

$

Basic Structure of the Eminent Domain Plan

Notes: The double-headed arrow represents class overlap rather than a flow. The twovertical arrows crossing the dotted line represent a detour between the bad loan andgood loanarrows.MBS is mortgage-backed securities;PLSis private-label securitization.


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prospective homeowner beneiciaries once qualiying loansare identiied. Financial advisory assistance, in turnwhether rom a ederal entity like the Federal HousingAdministration, rom private providers, or bothwill behelpul in most cases both in restructuring loans and inarranging investor compensation.

Te Plans Legal Basis: aking Intangibles or Public Purposeand Paying Fair ValueHow commonly is eminent domain used or more thancompulsory land purchases or roads and bridges? Toughnon-lawyers are not always aware o the act, governmentalauthorities compulsorily purchase property at air value orpublic use all the time (Hockett 2012a, Section IV). And theydo so with all manner o propertytangible and intangible,contractual and realty-related alike.

Forms o intangible property that have been purchased

in eminent domain include bond tax exemption covenants,insurance policies, corporate equities, other contract rights,businesses as going concerns, and even sports ranchises(Hockett 2012a). Because the law draws no distinctionsbetween kinds o property that can be purchased in eminentdomain, it is unsurprising that loans and liens in particular,as one orm o contractual obligation among many, arethemselves regularly purchased.12 Among these aremortgage loans and liens, as the Supreme Court and statecourts have long recognized.13

Te question, then, is not what kinds o property can betaken, but whether a public purpose justies the taking andair value is paid. Preventing more oreclosures, blighted

properties, revenue base losses, and city service cutbacksis recognized by courts as the most compelling o publicpurposes justiying use o the eminent domain authority.14As or air value, how is this determined? Wont municipalitieshave to purchase loans at less than air value to recoup enoughmargin to compensate the investors, public or private, whoput up the purchase money?

First, on valuation, there are multiple methods available.Where mortgage-backed securities associated with a particularloan pool or analogous pools trade at a discount, or example,imputation o counterpart discounts to underlying loans isarithmetically straightorward. And private-label securitiza-

tion bonds, it bears noting, are trading at very steep discounts.

12 Phillips v. Washington Legal Foundation, 524 U.S. 156 (1998) (accruedinterest on account unds);Armstrong v. United States, 364 U.S. 40 (1960)(materialmans lien); and the iconic Legal ender Cases, 79 U.S. (12 Wall)457 (1870). See, generally, Hockett (2012a).

13 Louisville Joint Stock Land Bank v. Radord, 295 U.S. 555, 602; W. Fertilizer& Cordage Co. v. City o Alliance, 504 N.W.2d 808, 816 (Neb. 1993). Again, seeHockett (2012a).

14 Kelo v. City o New London, 545 U.S. 469 (2005).

Te latest data rom Amherst Securities on PLS senior debt,or example, are telling, as are estimates o senior bonds aspercentages o total bonds outstanding and prices thereo

aspercentages o unpaid principal balances (see table above).Where bond-to-loan discount-imputation is unavailable

owing to missing markets, discounted cashow methods willdo. As noted above, or example, Fannie Mae and Freddie Macpublish expected deault rates or sundry classes o under-water PLS mortgages each year. From thesealong withoreclosure costs, associated recovery rates (generally no morethan 22percent on deaulted loans), and discount ratesthecalculation o net present values is not a recondite exercise.And our courts, which routinely hear valuation arguments inmultiple contexts and oen impanel experts, will oversee theproceedings as required by law, ensuring airness to parties.

Even this saeguard might be more than is necessary, however,i ederally overseen valuation summits o the kind mentionedabove and discussed urther below should prove workable.

What about the putative need to pay current investorsless than air value to compensate new ones? Must onerob Peter to pay Paul? he answer is no. Eminent domainproceedings need not represent zero sum games. By avert-ing market ailuresand the needless sacriice o valuethat these ailures entailthe plan proposed here recoupsvalue, which can then be equitably distributed to render allstakeholders better o.

First lienholders who help nance the purchases rom their

PLS trusts receive loans that are higher in expected value inexchange or loans with lower expected value. First lienholderswho do not thus participate receive air value or otherwiseunmarketable assets. (Tis is so even i trustees in some casesmust divide proceeds among subclasses.) Homeowners receivemodest equity in their homes and diminished deault andoreclosure risk. Neighbors see their communities, propertyvalues, and municipal services stabilized, while municipalitiessee property tax revenues restored and abatement costs drop.Even second lienholders can benet i paid a small raction o

Sni Bnd Picing f Pivat Labl ScitizatinTsts: Agst 2012

Price as aPercentage o

Senior Bond

Senior Bond

Percentage o otal

Price as aPercentage

o Loan UPBSubprime 55.7 90.0 50.1

Option ARM 58.5 90.0 52.7

Alt-A ARM 66.7 90.0 60.0

Alt-A Fixed 73.1 90.0 65.8

Source: Amherst Securities.

Notes: UPB is unpaid principal balance.ARMis adjustable-rate mortgage;Alt-A is Alternative-A, a risk classication between prime and subprime.


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the value recouped by the write-downs, since in oreclosurethey receive nothing.

Why the National Problem Is First a Local ProblemIt was suggested earlier that state and local governments mightbe better situated than the ederal government to take the leadin pursuing a plan like that sketched in this articleeven iederal instrumentalities might play helpul supporting roles.

Why is this the case? In what sense do localities ace the worsto the mortgage debt overhang problem, and thus have incen-tive to act rst?

he answer is that even though the problem is ultimatelynational in scope, its worst symptoms are locally concentrated.In some communities, more than 80percent o PLS loans areunderwater. Te degree to which the loans are underwater,moreover, can be dramatic: some communities underwaterPLS loans have average loan-to-value (LV) ratios greater

than 200percent, and many more have ratios approachingthat number. Te map above aords a telling, i understated,15picture o how localized the worst o the nations underwatermortgage problems actually are.16

Concerns Raised by the Eminent Domain PlanWhile it is not possible here to anticipate and ully addressall concerns that the eminent domain plan might invite,

one can cover the most obvious ones in broad outline.hese all under two headingsconcerns o the sort thatdebt write-downs seem always to raise, and concernsrelating to the reliance on state rather than ederalauthority to implement the plan.

15 Te chart covers all underwater loans, and does not distinguish high-LVloans rom lower-LV loans.

16 CoreLogic Negative Equity Report, Fourth-Quarter 2012, available athttp://www.corelogic.com/.

Source: CoreLogic Negative Equity Report.

Underwater Mortgages as a Share of All Mortgages, by CountyAs of Fouth-Quarter 2012

0% to 25%

25% to 35%

35% to 45%

45% to 55%

55% and above


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Debates over the justice and eciency o debt orgivenessare long-standing. Critics say that contracts are bindingcommitments that must be upheld, while proponents o debtorgiveness say some debts are odious. Again, critics saythat write-downs induce moral hazard and reduce creditavailability, while proponents observe that you cannotsqueeze blood rom turnips. We are not going to settlesuch perennial questions here, any more than the Book oLeviticus or centuries o law versus equity have done. Butthree things bear noting.

First, owing to asset-price bubbles status as collectiveaction problems, it is doubtul that many homebuyers duringthe bubble years had much choice when it came to buyingovervalued homes. Tat mosthomes were overvalued is whatrendered the bubble a bubble. It thereore seems mistakento blame homeowners as a class, or to characterize write-downs as per se unair or morally hazardous. It is also easy toormulate loan-selection criteria in ways that do not encourage

strategic deaults going orwardby reerence to LV/deaultcorrelations as suggested above (Hockett 2012a, 2013, 2010).

Second, or similar reasons, there seems little need toear long-term contraction in liquidity or credit. Bubblesinate only when credit is overabundant. We want, then,some credit-caution in uture, just not too much. And wewant to get to that middle ground as quickly as possible. Tebest way to do this is rst to clear out the overhang underwhich 11 million homeowners still struggle, then to ensurethat the pooling and servicing agreements or residentialmortgage-backed securities going orward look more likethe agreements or commercial mortgage-backed securities

always have lookedproviding in advance or value-salvagingmodications on a scale unanticipated beore the most recentcrisis, and thereby preempting the uture need to resort tosuch methods as the one proposed here.17 New residentialmortgage securitizations suggest that the latter change isalready under way. o resolve what earlier securitizations havewrought, however, requires a plan like that outlined above.

Finally, it is important to recall that write-downs are doneon nonmortgage debt all the time. We call it bankruptcy, andaord it to rms because it salvages value. Te plan proposedhere does the same. And as noted above, the value thus savedcan be shared among all stakeholder classes.

urning now to issues linked to the plans reliance onstate, rather than ederal, authority, we nd some concernsstemming rom possible dierential application o theeminent domain plan across states and localities. Floridacounties, or example, might construct variants o theplan that dier rom those adopted by Louisiana parishes.Caliornia or Michigan plans might diverge rom both. Wouldsuch dierences raise airness concerns?

17 For more on the dierences between RMBS and CMBS pooling andservicing agreements, see Hockett (2012b).

he question is a complex one. We should certainlywelcome some degree o national uniormity (this is onereason the present author [2009] irst proposed ederal,not state or local, action in 2008). But local conditionsdo vary rom county to county, such that airness itseldictates some variation. It is also the case that our ederalsystem already involves quite signiicant state variationwith respect to all manner o lawrom property, tort, andeven commercial law to electoral law. here will be nothingparticularly unusual, then, in diering states cratingdiering variants o the plan here proposed. It might evenbe welcomeor the usual laboratories o democracyreasons given or local experimentation.

All o that said, however, ederal agencies could be helpulin conning local variation within reasonable bounds, aswell as in promoting ecient and amicable loan workoutsnationwide along lines like those here proposed. By bring-ing municipal or state, homeowner, bondholder, and bank

representatives together under one summit structure, thereasury, Federal Housing Finance Agency, Federal ReserveBoard or regional banks like the Federal Reserve Bank oNew York operating thereunder, the Department o Hous-ing and Urban Development, or some combination thereocould acilitate consensus among all concerned parties on thebasic contours that all local variants o the eminent domainplan should take. Tere is no reason this consensus could notinclude loan-selection and loan-valuation principles as well asmore detailed practical elements.

Conclusion: It akes a Villagebut a FederalGovernment HelpsTe guiding ideal in any such summit as that proposedhere should be to convert the eminent domain tool into amere ormality enabling all interested parties to sidestepdysunctional pooling and servicing agreements consensuallyand thereby recapture lost value. Getting past these contractsand the collective action problems they underwrite is, aerall, precisely and solely what this plan is or. States and theirsub-units are best situated at this point to act. But ederalagencies could be helpul acilitators or all.

Te author thanks Kaushik Basu, Michael Campbell,TomasDeutsch, Laurie Goodman, Howell Jackson,DariusKingsley, Christopher Mayer, Brad Miller, LawrenceRurano, Robert Shiller, Joseph racy, Lauren Willis, andother colleagues at the Federal Reserve Bank o New York,the Federal Reserve Board, the Federal Deposit InsuranceCorporation, the Federal Housing Finance Agency, theInternational Monetary Fund, the reasury Department,and the World Bank, as well as in the academy, or helpulcomments. Te views expressed are nevertheless his ownand not attributable to others absent express conrmation.Some o those named here oppose the proposal.


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9

Reerences

Appelbaum, Binyamin. 2012. Housing Finance Agency Rebus Freddieand Fannie on Easing Debt.New York imes, July 31. Available at http://www.nytimes.com/2012/08/01/business/us-agency-bars-annie-and-reddie-rom-reducing-principal.html.

Campbell, Michael, and Robert Hockett. 2012a. Proposal to Adopt the HomeMortgage Bridge Loan Program. Available at http://www2.nycbar.org/pd/report/uploads/9_20072233-BridgeLoanAssistanceProgram.pd.

. 2012b. Some Homeowners Need Just emporary Aid.AmericanBanker, May 24. Available at http://www.americanbanker.com/bankthink/Mortgage-bridge-loan-New-York-City-Bar-1049605-1.html.

. 2012c. White Paper in Support o the Home Mortgage Bridge LoanAssistance Act o 2012. Cornell Legal Studies Research Paper no. 12-03.Available at http://papers.ssrn.com/sol3/papers.cm?abstract_id=1987159.

Church, Steven, Dawn McCarty, and Michael Bathon. 2012. San Bernardino,Caliornia, Files Chapter 9 Bankruptcy. Bloomberg, August 2. Available athttp://www.bloomberg.com/news/2012-08-02/san-bernardino-caliornia-les-or-bankruptcy-protection-2-.html.

Dudley, William. 2012. Housing and the Economic Recovery. Remarks atthe New Jersey Bankers Association Economic Forum, January 6. Available athttp://www.newyorked.org/newsevents/speeches/2012/dud120106.html.

Federal Reserve Board. 2012. Te U.S. Housing Market: Current Conditionsand Policy Considerations. White Paper, January 4.

Goodman, Laurie S. 2012. estimony to the U.S. Senate Subcommitteeon Housing, ransportation, and Community Development, March 15.Available at http://banking.senate.gov/public/index.cm?FuseAction=Files.View&FileStore_id=096e0-8500-41a5-a02-0139d0d2e07.

Goodman, Laurie, et al. 2012.Amherst Mortgage Insight: Non-AgencyMBSDecomposing the Returns, September 27.

Hockett, Robert. 2009. Bailouts, Buy-ins, and Ballyhoo. Challenge 52, no. 36.

. 2010. Bubbles, Busts, and Blame. Cornell Law Forum 32, no. 3.

. 2012a. It akes a Village: Municipal Condemnation Proceedingsand Public/Private Partnerships or Mortgage Loan Modication, ValuePreservation, and Local Economic Recovery. Stanord Journal o Law,Business, and Finance 18, no. 1 (Fall): 121. Prepublication dra available athttp://papers.ssrn.com/sol3/papers.cm?abstract_id=2038029.

. 2012b. Six Years On and Still Counting: Siing through the MortgageMess. Hastings Business Law Journal9, no. 1: 373. Prepublication draavailable at http://papers.ssrn.com/sol3/papers.cm?abstract_id=2029262.

. 2013. Recursive Collective Action Problems.Journal o AppliedEconomics 5, no. 1 (orthcoming).

Hockett, Robert, and Michael V. Campbell. 2012. A Bridge to ViableMortgages.Albany imes-Union, June 14. Available at http://www.timesunion.com/opinion/article/A-bridge-to-viable-mortgages-3635265.php.

Jackson, Howell E. 2008. Build a Better Bailout. Christian Science Monitor,

September 25.

Kuttner, Robert. 2010.A Presidency in Peril: Te Inside Story o ObamasPromise, Wall Streets Power, and the Struggle to Control our Economic Future.White River Junction, Vt.: Chelsea Green Publishing.

Lee, Donghoon, Christopher Mayer, and Joseph racy. 2012.A New Look atSecond Liens, Federal Reserve Bank o New YorkSta Reports, no. 569, August.Available at http://www.newyorked.org/research/sta_reports/sr569.html.

Miller, Brad. 2010. UnHAMPered: FDRs Superb Fix or Our Housing Crisis.New Republic, February 24, 2010. Available at http://www.tnr.com/article/unhampered#.

Olick, Diana. 2012. Is Housing Recovering as Much as Everyone Tinks?Realty Check 9, October. Available at http://www.cnbc.com/id/49343717/Is_Housing_Recovering_as_Much_as_Everyone_Tinks.

Orr, James, John Sporn, Joseph racy, and Juneng Huang. 2011. Help orUnemployed Borrowers: Lessons rom the Pennsylvania HomeownersEmergency Mortgage Assistance Program. Federal Reser ve Bank o New YorkCurrent Issues in Economics and Finance 17, no. 2. Available at http://newyorked.org/research/current_issues/ci17-2.html.

Ritholtz, Barry. 2012. Fascinating Mortgage and Housing Data Points.Te Big Picture (blog), June 17. Available at http://www.ritholtz.com/blog/2012/06/ascinating-mortgage-housing-data-points/.

Shiller, Robert. 2012. Real Estates Collective Action Problem.New Yorkimes, June 23. Available at http://www.nytimes.com/2012/06/24/business/economy/real-estates-collective-action-problem.html.

Shoen, John. 2012. Foreclosure Fallout Cost Nearby HomeownersNearly $2 rillion, Report Finds.Economy Watch, October 24.

Available at http://www.nbcnews.com/business/economywatch/oreclosure-allout-cost-nearby-homeowners-2-trillion-report-nds-1C6663420.

Streiteld, David. 2011. Big Banks Easing erms on Loans Deemed as Risks.New York imes, July 2. Available at http://www.nytimes.com/2011/07/03/business/03loans.html?_r=0.

Willis, Lauren E. 2008. Stabilize Home Mortgage Borrowers, and theFinancial System Will Follow. Loyola-LA Legal Studies Paper no. 2008-28.Available at http://papers.ssrn.com/sol3/papers.cm?abstract_id=1273268.

Te views expressed in this article are those o the author and do not necessarily refect the position o the

Federal Reserve Bank o New York or the Federal Reserve System.

Current Issues in Economics and Financeis published by the Research and Statistics Group of the Federal Reserve Bank of New York.

Linda Goldberg and Thomas Klitgaard are the editors of the series.

ABouT The AuThor

Robert Hockett is a professor of financial law subjects at Cornell Law School, a former visiting scholar at the Federal Reserve Bank

of New York, and, while on sabbatical during the 2012-13 academic year, consulting counsel at the International Monetary Fund.

He serves frequently as an unpaid consultant on finance-regulatory and mortgage-related matters to consumer and financial reformgroups as well as to legislators, regulators, and other officials at all levels of government. In 2012, he received a fee from the firmMortgage Resolution Partners to provide legal analysis of questions raised by his eminent domain proposal in the state of California.

All of his current work on the foreclosure crisis and eminent domain plan, for public and private entities alike, is done gratis.


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CurreNT ISSueS IN eCoNoMICS AND FINANCeVolume 19, Number 5

Publications o the Research and Statistics GroupAvailable at http://www.newyorked.org/research/publication_annuals/index.html

Te Financial Crisis at the Kitchen able: rends inHousehold Debt and Credit

Meta Brown, Andrew Haughwout, Donghoon Lee,and Wilbert van der KlaauwCurrent Issues in Economics and Finance, vol. 19, no. 2, 2013

Since the onset o the nancial crisis, households have reducedtheir outstanding debt by about $1.3 trillion. While part othis reduction stemmed rom a historic increase in consumerdeaults and lender charge-os, particularly on mortgagedebt, other actors were also at play. An analysis o the New York

Feds Consumer Credit Panela rich new data set on individualcredit accountsreveals that households actively reduced theirobligations during this period by paying down their currentdebts and reducing new borrowing. Tese household choices,along with banks stricter lending standards, helped drive thisdeleveraging process.

Securitization and the Fixed-Rate Mortgage

Andreas Fuster and James VickeryStaf Reports, no. 594, January 2013

Fixed-rate mortgages (FRMs) dominate the U.S. mortgagemarket, with important consequences or household risk

management, monetary policy, and systemic risk. Tis studyshows that securitization is a key driver o FRM supply. Teanalysis compares the agency and nonagency mortgage-backed-securities (MBS) markets, exploiting the reeze innonagency MBS liquidity in the third quarter o 2007. Usingexogenous variation in access to the agency MBS market,the authors nd that when both market segments are liquid,they perorm similarly in terms o supporting FRM supply.However, aer the nonagency market reezes, the shareo FRMs is sharply higher among mortgages eligible to besecuritized through the still-liquid agency MBS market. Teauthors conclude that securitization is particularly importantor FRMs because o the prepayment and interest rate riskembedded in these loans. Tey highlight policy implicationsor ongoing reorm o the U.S. mortgage nance system.

Payment Size, Negative Equity, and Mortgage Deault

Andreas Fuster and Paul S. WillenStaf Reports, no. 582, November 2012

Surprisingly little is known about the importance o mortgagepayment size or deault, as eorts to measure the treatmenteect o rate increases or loan modications are conounded

by borrower selection. Tis study examines a sample o hybridadjustable-rate mortgages that have experienced large ratereductions over the past years and are largely immune to theseselection concerns. Te authors show that interest rate changesdramatically aect repayment behavior. Teir estimates implythat cutting a borrowers payment in hal reduces his hazardo becoming delinquent by about two-thirds, an eect that isapproximately equivalent to lowering the borrowers combinedloan-to-value ratio rom 145 to 95 (holding the payment xed).Tese ndings shed light on the driving orces behind deaultbehavior and have important implications or public policy.

A New Look at Second Liens

Donghoon Lee, Christopher Mayer, and Joseph racyStaf Reports, no. 569, August 2012

Te authors use data rom credit reports and deed records tobetter understand the extent to which second liens contributedto the housing crisis by allowing buyers to purchase homeswith small down payments. At the top o the housing market,second liens were quite prevalent: As many as 45 percento home purchases in coastal markets and bubble locationsinvolved a piggyback second lien. Owner-occupants weremore likely to use piggyback second liens than were investors.Second liens in the orm o home equity lines o credit(HELOCs) were originated to relatively high-quality borrowers,and originations were declining near the peak o the housingboom. By contrast, characteristics o closed-end second liens

(CES) were worse on all these dimensions. Te deault rate othe second lien is generally similar to that o the rst lien onthe same home, although HELOCs perorm better than CES.About 20 to 30 percent o borrowers will continue to pay theirsecond lien or more than a year while remaining seriouslydelinquent on their rst mortgage. By comparison, about40 percent o credit card borrowers and 70 percent o autoloan borrowers will continue making payments a year aerdeaulting on their rst mortgage. Finally, the authors showthat delinquency rates on second liens, especially HELOCs,have not declined as quickly as those on most other typeso credit, raising a potential concern or lenders with largeportolios o second liens on their balance sheets.

Payment Changes and Deault Risk: Te Impact oRefnancing on Expected Credit Losses

Joseph racy and Joshua WrightStaf Reports, no. 562, June 2012

Tis paper analyzes the relationship between changes inborrowers monthly mortgage payments and uture creditperormance. Te relationship is important or the design oan internal renance program such as the Home Aordable

reLATeD reADINGS FroM The FeDerAL reSerVe BANK oF NeW YorK


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www.newyorked.org/research/current_issues11

reLATeD reADINGS FroM The FeDerAL reSerVe BANK oF NeW YorK (Continued)

Renance Program (HARP). Te authors use a competing riskmodel to estimate the sensitivity o deault risk to downwardadjustments o borrowers monthly mortgage payments or

a large sample o prime adjustable-rate mortgages. Applyinga 26 percent average monthly payment reduction that theyestimate would result rom renancing under HARP, theauthors nd that the cumulative ve-year deault rate on primeconorming adjustable-rate mortgages with loan-to-value ratiosabove 80 percent declines by 3.8 percentage points. Assumingan average loss given deault o 35.2 percent, the authorsdetermine that this lower deault risk implies reduced creditlosses o 134 basis points per dollar o balance or mortgages thatrenance under HARP.

Real Estate Investors, the Leverage Cycle, and

the Housing Market CrisisAndrew Haughwout, Donghoon Lee, Joseph racy,and Wilbert van der KlaauwStaf Reports, no. 514, September 2011

Tis study explores a mostly undocumented but importantdimension o the housing market crisis: the role played byreal estate investors. Using unique credit-report data, theauthors document large increases in the share o purchases,and subsequently delinquencies, by real estate investors.In states that experienced the largest housing booms andbusts, at the peak o the market almost hal o purchasemortgage originations were associated with investors. In part

by apparently misreporting their intentions to occupy theproperty, investors took on more leverage, contributing tohigher rates o deault. Te authors ndings have importantimplications or policies designed to address the consequencesand recurrence o housing market bubbles.

Help or Unemployed Borrowers: Lessons rom thePennsylvania Homeowners Emergency MortgageAssistance Program

James Orr, John Sporn, Joseph racy, and Juneng HuangCurrent Issues in Economics and Finance, vol. 17, no. 2,April 2011

In an environment o high oreclosure rates and distressedhousing markets, ederal policies are ocusing on loanmodications to help delinquent homeowners pay theirmortgages. While it is too soon to assess the eectivenesso these modications, policymakers considering uturerenements may gain insight rom a more established, state-

level enterprise that takes an alternative approach to mortgagerelie. Te Pennsylvania Homeowners Emergency MortgageAssistance Program provides temporary income support to

homeowners unable to pay their mortgage during a spell ounemployment. Te program has helped most participantsretain their homes while paying o their loansat apotentially lower cost than that o other relie initiatives.

A Private Lender Cooperative Model or ResidentialMortgage Finance

oni Dechario, Patricia Mosser, Joseph racy, James Vickery,and Joshua WrightStaf Reports, no. 466, August 2010

Tis paper describes a set o six design principles or the

reorganization o the U.S. housing nance system and appliesthem to one model or replacing Fannie Mae and Freddie Macthat has so ar received requent mention but little sustainedanalysisthe lender cooperative utility. Te authors discussthe pros and cons o such a model and propose a methodor organizing participation in a mutual loss pool and anexplicit, priced government insurance mechanism. Tey alsodiscuss how these principles and this model are consistentwith preserving the to-be-announced, or BA, marketparticularly i the xed-rate mortgage remains a ocus opublic policy.

Second Chances: Subprime Mortgage Modifcation

and Re-DeaultAndrew Haughwout, Ebiere Okah, and Joseph racyStaf Reports, no. 417, December 2009, revised August 2010

Mortgage modications have become an important componento public interventions designed to reduce oreclosures. Tisstudy examines how the structure o a mortgage modicationaects the likelihood o the modied mortgage re-deaultingover the next year. Using data on subprime modicationsthat precede the governments Home Aordable ModicationProgram, the authors ocus attention on those modicationsin which the borrower was seriously delinquent and themonthly payment was reduced as part o the modication.

Te average re-deault rate over the twelve months ollowingthe modication was 56 percent. Te data indicate that there-deault rate declines with the magnitude o the reduction inthe monthly payment, but also that the re-deault rate declinesrelatively more when the payment reduction is achievedthrough principal orgiveness as opposed to lower interest rates.


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Press Briefng on Household Debt and Credit

Meta Brown, Andrew Haughwout, Donghoon Lee,Joelle Scally, and Wilbert van der KlaauwLiberty Street Economics blog, February 28, 2013

Underwater and Drowning? Some Facts about Mortgagesthat Could Be argeted by Eminent Domain

Andreas Fuster, Caitlin Gorback, and Paul WillenLiberty Street Economics blog, February 13, 2013

Has Household Deleveraging Continued?

Andrew Haughwout, Donghoon Lee, Joelle Scally,and Wilbert van der KlaauwLiberty Street Economics blog, August 29, 2012

Have Consumers Been Deleveraging?

Meta Brown, Andrew Haughwout, Donghoon Lee,

and Wilbert van der KlaauwLiberty Street Economics blog, March 21, 2011

Website Resource

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Available at http://www.newyorked.org/householdcredit/

Te Federal Reserve Bank o New Yorks Household Debt andCredit Reportprovides a quarterly snapshot o householdtrends in borrowing and indebtedness, including data aboutmortgages, student loans, credit cards, auto loans, anddelinquencies. Te report aims to help community groups,

small businesses, state and local governments, and the publicto better understand, monitor, and respond to trends inborrowing and indebtedness at the household level.

reLATeD reADINGS FroM The FeDerAL reSerVe BANK oF NeW YorK (Continued)

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