The Folly of Eminent Domain Takings of Failing Mortgage Loans

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University of Arizona economist Price Fishback, who has been on this blog before, is one of the leading scholars of the economics of the New Deal. He has a great new set of insights to share on the U.S. mortgage mess. He’s also the co-author of the forthcoming book Well Worth Saving: How the New Deal Safeguarded Home Ownership, with Jonathan Rose and Kenneth Snowden.

The Folly of Eminent Domain Takings of Failing Mortgage Loans
By Price Fishback

Several cities around the country are considering using eminent domain to take control of troubled mortgages in their cities.  An Associated Press example of how the proposal will work calls for the city to use eminent domain to force the lender to accept $150,000 for a $300,000 mortgage on a home that has a current market value of $200,000.  The city would then refinance the loan while cutting the principal owed by the borrower to $190,000.    

Eminent domain requires a public purpose for the taking of an asset.   The public purpose claimed here is that property values and property tax revenues can be boosted by preventing a mass of foreclosure sales.  Real estate studies do show that increasing numbers of foreclosure sales are associated with lower housing values in nearby neighborhoods.  However, the spillover benefits of preventing foreclosures, tend to be focused on houses in nearby neighborhoods. 

These benefits have to be weighed against the chilling effects on mortgage lending of the eminent domain procedure.   The states that adopted temporary mortgage moratoria laws to stop or slow foreclosures in the 1930s experienced sharp cuts in lending after the laws ended.  Those who could still get loans paid higher interest rates that raised their monthly payments by about 1 percent.  These moratoria imposed mild losses on lenders relative to the losses implied by the suggested eminent domain procedure.  I would not be surprised if the increased risk implied by the eminent domain process raised mortgage interest rates by half a percent or more, which would drive monthly payments on homes up by 5 percent or more with roughly equivalent damage to housing prices.  These are the future costs at the local level.  If the program is found constitutional, it sets a precedent that will lead to nationwide negative effects on all mortgage lending.    

Then there is the question of whether the $150,000 payments to lenders meet the requirements of eminent domain law to pay the lender the fair value of the asset taken.  If the city anticipates that they will refinance a $190,000 loan with success, then the true value of the asset is $190,000 because the lender ostensibly could do the same thing.  If the city believes the true value of the loan is only $150,000, they must be presuming that the risk on the $190,000 refinancing is pretty large. 

Where will they get the funds to pay for this?  A property tax or sales tax rise might easily have as large a negative impact as the benefit to house prices of preventing foreclosures. Alternatively, the city might go to the bond markets to raise capital, but it is offering investors a risky proposition and likely will have to pay higher interest rates to reflect the increased risk.  It has been suggested that the cities might receive low interest loans from the federal government. Even so, it is highly likely that the refinancing will not end the mortgage foreclosure problem. 

When Roosevelt’s New Deal created the Home Owners’ Loan Corporation (HOLC) to purchase one million troubled mortgages from lenders and refinance them in the 1930s, the HOLC after 1934 could issue bonds at a risk free interest rate because the federal government guaranteed the HOLC bond.  This allowed the HOLC to charge low interest rates on the refinances and offer lower monthly payments to borrowers.  Despite these advantages and the HOLC’s willingness to allow borrowers a great deal of leeway before foreclosing on the loans, the HOLC foreclosed on nearly 20 percent of their loans by 1939 and still faced three-month or more delinquency rates of 25% of the remaining loans.  In the modern era the Homes Affordable Modification Program (HAMP) has experienced redefault rates of 26 percent according to a July report on TARP outcomes.      

A number of people have suggested that the HOLC might be a model for how to proceed with dealing with the mortgage foreclosure problem.  The HOLC did not use eminent domain.   Lenders voluntarily sold loans to the HOLC because the HOLC offered prices that typically covered the full principal owed and unpaid interest as well as back taxes paid by the lender.  The HOLC essentially replaced the toxic assets on lenders’ books with guaranteed assets.  The modern day Homes Affordable Mortgage Program (HAMP) does not purchase loans but provides some subsidies for lenders to refinance homes.  This difference in policy is one reason why the HAMP has led to the refinancing of only about one-fourth of its expected activity. In contrast, the eminent domain policies forces lenders to take a very large haircut.

The HOLC also did not offer principal reductions to the borrowers.  Instead, they asked the borrower to repay the full amount that the HOLC paid for lenders for the loan.  The borrower gained because the HOLC offered a below market interest rate and an expanded repayment period.   The HAMP has followed a similar policy for the lion’s share of its loans, but does have a small program that offers principal reductions.    

The HOLC ultimately was a successful program.  It helped both lenders and borrowers, and only incurred ex post losses to taxpayers of about 2 percent of the value of the loans.  The HOLC also had strong positive effects in over 2,000 small housing markets where it staved off further declines in housing values and home ownership rates after 1934.   The main subsidy to mortgage markets came in the form of the HOLC bond guarantees, which were likely were about 20 percent of the value of the loans. 

The HOLC and HAMP are much more sensible ways to deal with the housing foreclosure problems than using eminent domain.  Both have helped lenders while aiding borrowers at the same time.   The eminent domain solution harms lenders.  In the short run it will help borrowers who receive the refinances, but in the long run will harm a large number of other borrowers.  This seems a high spillover cost to pay for at best a temporary gain for some property holders in some cities.    

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  1. Steve Cebalt says:

    The greatest concern I have with these schemes is that they further pervert the purpose of eminent domain. Much like when private homeowners are displaced to make room for another private developer to build hotels or other large developments that will generate more property tax revenue — and profit to the developer — at the expense of private property owners who do not want to be displaced. It’s one thing to “take” a private property to build a bridge, a road, or a school. It is quite another to seize a modest home and transfer possession to another, more affluent private owner. After all, when the government can take your property for any reason, or for no reason, what does “ownership” even mean? In this case it is the lenders who are getting hosed.

    To exercise the power of eminent domain, the government must prove that the four elements set forth in the Fifth Amendment are present: (1) private property (2) must be taken (3) for public use (4) and with just compensation.

    Programs like this further distort the concept of eminent domain, which is something ever property owner should fear.

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    • Someone says:

      Even how eminent domain was originally used should not have been allowed. After all, what is just compensation? Even though the market value of a house is, for example, $200,000, THAT individual might find the house to be worth $1 million for whatever reason. If that’s the case, it would take at least $1 million to make the person willingly leave. The way eminent domain should be done (if at all) is to make the government purchase it from the homeowner. The government would offer to pay an amount. If it is not worth it for that person to move, the government would have to offer a higher amount. If the government is unwilling to pay that higher amount, then it should be unable to take the person’s house. I think this is the only way to have truly just compensation. Until this is the way the government compensates people for leaving, I will remain against any and all uses of eminent domain.

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      • Mike B says:

        The point of eminent domain is to achieve the greatest benefit to the community in the face of obstructionist individuals. The government paying whatever the last holdout demands isn’t called eminent domain, it’s just normal market practices. Remember the good of the many outweighs the rent seeking behavior of the few, or the one.

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  2. Eric says:

    But the negative consequences of the eminent domain method just sound like a market correction to me. If the problem was that too many mortgages were sold too cheaply and lenders made too much money, then these effects of forcing lenders to take a haircut and then lend more prudently are just what is needed. What looks like punishing lenders to me looks like internalizing systemic risk.

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    • Brian says:

      The lendors make the same amount of money. Their profits won’t erode. Consumers will pay a higher fee through the .5-1% higher mortgage rates.

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  3. Allen says:

    While agree with the author’s position on eminent domain, the insanity of the lenders must be addressed. What rational can a lender use for foreclosing and selling at a fraction of the loan value when by simply refinancing and lowering interest rates, extending payments or even placing the loan as an interest only loan for some time period till the homeowner gets back on their feet or the housing market recovers they could recover more or all of their principle value?

    I saw a house with a loan value of $215,000 sold at auction for $80,000 and resold within a few months at $125,000. If the bank had been willing to work with the home owner to refinance at the then current interest rate and extend the 21 year remaining mortgage to 30 years the homeowner could have kept the loan current until the market would support selling the home for more than the loan value. At the very least the bank could have help with a short sale that would have reduced their losses significantly.

    What is a municipality to do when the banks insane practices impact the community as a whole?

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    • Jason says:

      BofA refused to help us refinance our loan. We have a relatively large mortgage and almost no risk of default (high credit scores, etc). They clearly assessed that they could lie, deflect, and make my life so difficult that I would give up and keep paying 6.5%.

      Instead, I found a lender willing to refinance me at 4.25% (using the same programs that BofA swore I was ineligible for). It was a nightmare to finally find someone to do it, but it got done. So, BofA lost a good customer for the next 30 years. If I were a BofA shareholder, I would question the short-term gain behavior of the leadership.

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      • Bill McGonigle says:

        And yet there’s the trend of an dwindling number of mortgage originators due to increasing regulations, making it harder and harder to find those competitors to the banks that are holding most of the cards (or is it deeds?).

        There is so much market perversion it’s hard to even see where the least-bad way out of the mess is.

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  4. James says:

    Could it not be argued that the actual value of a $300K mortgage is in fact closer to $300K than to the $150K the city wants to pay, or the $190K it hopes to refinance for? Especially since, given the current rebound in housing prices, and the speed at which the legal system acts, the underlying house could well be back to a $300K market value before the case works its way through the courts.

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  5. Someone says:

    The biggest problem I have with eminent domain as it’s done today is the government’s idea of “just compensation”. For example, the market value of a person’s hove could be $200,000. THAT individual may, however, might find the house worth $500,000. In this case offering $200,000 would not be just compensation because the person would be unwilling to move for anything less then $500,000. The way eminent should be done if at all would be to have the government purchase the home from the owner. The government would offer a certain amount. If the person is unwilling to move for that amount of money, the government should have to provide a larger amount (until the person is willing to leave). If the government is unwilling to pay that amount for the house, it should be unable to take that person’s house at all (no matter how beneficial the government’s goals are for society). This way, both the government and the homeowner are better off as a result of the move. Until the government follows this procedure, I will be against any and all cases of eminent domain, as anything less is not “just compensation”.

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    • Mike B says:

      If one holdout was depriving a community of a valued improvement project then it would not surprise me if that holdouts house caught fire one night. If you’re going to go all super libertarian opposing government then be aware that your neighbors are going to have to resort to alternate mechanisms of enforcing community goals. The community will always do what is in the community’s best interest. Don’t expect your neighbors to value the ideal of property rights if that ideal is harming them in a practical manner. Thinking that the government should only do the things that benefit you, ie protect your property, without requiring anything in return, like paying taxes or living with an eminent domain system, is the epitome of selfishness.

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      • triclops41 says:

        So now the belief that the government should not simply seize your property to build a nice park or office building complex is a belief only held by wacko libertarians?
        You must think the vast majority of Americans are “super libertarians”.

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  6. Jim Reed says:

    “This difference in policy is one reason why the HAMP has led to the refinancing of only about one-fourth of its expected activity.” Who expected HAMP would do more and why?

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  7. Jason says:

    “The HOLC and HAMP are much more sensible ways to deal with the housing foreclosure problems than using eminent domain.”

    This implies that the cities have any control over such programs. These programs would have to come from Washington, which is not likely to move any time soon. So, the cities choose a less optimal solution just to move things forward.

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  8. Independent Third Party says:

    Kelo v. City of New London continues to distort property rights in this country. The full bundle of property rights is what banks lend on (fee simple) and if any of those rights are omitted from the asset being leveraged, smart lenders have grounds to increase the interest rate charged on that loan (increased risk = increased return, at least that’s the theory). It’s true that local municipalities need this foreclosure landscape cleaned up and it will take a lot of political courage to get a viable solution approved in today’s toxic partisan climate, but use of eminent domain is not the answer. The protection of property rights in the United States should be paramount for every law maker and citizen, including developers. I’m not sure why we have not learned from past mistakes to better navigate the current situation. A similar collapse in values occurred in the American southwest in the 1980s (although for different reasons), and the RTC was used as a tool along with the OTS and funding from REFCORP to manage the problem. It was not cheap and it took a long time for market dynamics to return to normalcy, but at least politicians weren’t tampering with the Fifth Amendment. If only Bill Seidman was still around to give us some pointers on this.

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    • Adrell says:

      I have a contract for deed (making payments on a loan through a private Investor) and just found out the city I stay in wants to buy the houses on my block will I be compensated for my house or will they compensate the private investor?

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