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.