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Published by: caitlynharvey on Jun 19, 2013
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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” homeowners—those who owe more on their mortgages than their houses are worth—is to reduce the principal on their home loans. Yet in the case o privatelysecuritized mortgages, such write-downs are almost impossibleto carry out, since loan modifcations on the scale necessitated by the housing market crash would require collective actionby 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 andthen plunged. Prices dropped nationally by 35 percent and still linger close to30 percent below peak levels. In harder-hit communities, prices are considerably more than 50 percent below peak.
While cyclical fuctuations push prices up or brie periods, 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 beore 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 o through February 2013. Tese fuctuations, highlighted in the moving average changemeasure in Chart 1, have been the pattern in home prices since 2009.While home prices—and hence home equity values—have allen and remainlow, the xed debt obligations that buyers had to take on to purchase homesunder bubble conditions have not. Consequently, approximately 11 millionhomes, or slightly less than a quarter o all homes with mortgages outstanding,are “underwater”—meaning that the balance on the mortgage exceeds thecurrent market value o the home. O these mortgages, between 3 million and4 million are in deault, in oreclosure, or oreclosed and awaiting liquidation.Over 2 million more are seriously delinquent—two-to-our payments in arrears(Olick 2012; Goodman et al. 2012; Ritholtz 2012; Goodman 2012).
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.
Volume 19, Number 5
Recognizing that deaults and oreclosures take a toll on theeconomic welare o communities and the nation as a whole,many analysts have called or the write-down o principal onmortgage debt as the most eective solution to the problem o underwater mortgages. As these analysts attest, write-downshave the important advantage o 
value.However, the diculty lies in carrying out the write-downs.While principal reduction on mortgages held in bank portoliosoccurs at signicant and still growing rates, loans held inprivate-label securitization (PLS) trusts have certain structuraleatures that make such reductions very rare. Specically, theseloans are subject to pooling and servicing agreements thatwould require collective action by a large majority o security holders beore the loans could be modied or sold out o trusts.Conducting such a collective action across most holders o thesecuritized loans would be nearly impossible.Tis edition o 
Current 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 “water”and thereby reducing the risk o deault.
Te Mortgage Debt Overhang: Scope o the Problem
Fewer than hal o the nations roughly 11 million underwatermortgages are current, and large numbers o these mortgagesgo delinquent each month:
ogether with loans that arealready delinquent or in deault, 7.5 to 9.5 million additionalhomes are expected to go into liquidation over the next severalyears absent remedial action.
Tese liquidations would urtherburden an already depressed market, yielding a backlog o vacant homes equal to 200
percent 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 weakened—ironically, 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 shrinking—an 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. Deaults and oreclosures in thehousing markets eed back into the macroeconomy througheects 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 andemployment, which in turn yield yet more deault and ore-closure, and so on (Hockett 2012a, 2012b, 2013).
Te Prudent Solution: Scaled Principal Write-Downs
Te most eective means o averting mortgage delinquency,deault, and oreclosure—and the associated economiccosts—is principal reduction. As even creditors recognize,
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.
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.
O course not all mortgage troubles are attributable to declining home values.Some homeowners ace diculty keeping current on payments or reasons o temporary 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, inormed by a successul Pennsylvaniaprogram developed during the early 1980s steel slump (Orr et al. 2011). A drabill 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 nation’s larger mortgage debt overhang problem will remainunaddressed (Campbell and Hockett 2012a, 2012b).
-3.0-2.5-2.0-1.5-1.0-0.500. moving averagechange in HPI20-city composite HPI 20122011201020092008 20072006 So
rce: Stan
& Poor’s/Case-Shiller Home Price In
ex (HPI).
Trends in Home Prices: July 2006–March 2013
Based on the Twenty-
ase-Shiller Home Price Index
Case-Shiller HPI
loss must be ormally recognized in a manner that bearssome intelligible relation to home
loss. Moreover, ormuch underwater mortgage debt, write-downs raise value—abenet borne out by the requency with which portolio loanholders write down debt (Olick 2012; Goodman et al. 2012;Ritholtz
2012; Goodman 2012).Write-downs are not easily carried out in all cases, however.Much depends on whether the targeted loans are held in bank portolios or by private-label securitization trusts. In the port-olio case, write-downs occur at signicant and still growingrates (Goodman et al. 2012; Goodman 2012; Streiteld 2011).Bank ocers 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 benet 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 benecial to write theseloans down, certain structural eatures o the loans—eaturesthat now act as market ailures—prevent the rational thingrom being done. Te upshot is deadweight loss—loss whoserecoupment and equitable distribution is one object o theplan sketched below.
Structural Impediments to Write-Downs
What are these structural impediments? A host o classiccollective action problems, reinorced by dysunctionalcontract 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 benets (positive externalities) that accrue tothe creditors on later loans when principal is reduced onearlier loans. Tis problem aicts portolio loans too, o course, and probably thereore keeps modication rates lowerthan optimal even among banks. But in the case o privately securitized loans, it is reinorced by additional challenges.Most decisive among the additional challenges is that somany o the pooling and servicing agreements governing theprivate securitization o loans—agreements draed during thebubble years when ew oresaw a marketwide housing price bust,and many rushed either to push or to purchase an innovativeproduct—require supermajority voting among mortgage-backedsecurities (MBS) holders beore loans can be modied 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 addresstheir collective action problems, rom modiying or sellingo loans in the requisite numbers (Hockett 2012a, 2012b).
 Finally, the agreements typically stipulate compensationarrangements that make it more protable or servicers tooversee lengthy oreclosure proceedings than to seek modica-tion.
In sum, then, these contracts now virtually ensure thatmortgage loans will deault, harming all interested parties.Additional complications arise rom the act that many underwater homes are subject to second liens that secure homeequity lines o credit or closed-end second mortgages. Firstlienholders benet little rom loan modications unless secondlienholders modiy too; hence, they are rationally reluctant tomodiy on their own. But second lienholders eel less pressureto modiy because borrowers, strapped by post-bust liquidity needs or which home equity lines constitute precious sourceso credit, are apt to make payments on them rst—a reversalo the legal order o creditor priorities (Goodman 2012).
Inaddition, the second lienholders quite oen are banks—thesame banks that service the rst-lien-secured loans. Tatposes a confict o interest where rsts preer that secondsmodiy too in order to optimize the benets that modica-tion brings to rsts, urther obstructing agreement amongborrowers and creditors.Other constraints—including inapplicable bankruptcy laws and Internal Revenue Code and rust Indenture Actuncertainties—impede the kind o collective action that wouldbenet both debtors and creditors (Hockett 2012a, 2012b). Butthe oregoing discussion suces to indicate how ormidablethe obstacles to principal write-downs can be, particularly orloans held in private-label securitization trusts.
Bypassing the Impediments through Collective Agency
Solving 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 oen hand-tied or con-ficted. 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. Tey are 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
govern-ment should take up this mantle—ederal, state, or local?
In some cases, or example, pooling and servicing agreements allow no morethan 5
percent o the loans in the pool to be modied. Tis
percentage, whichshows how little the marketwide crash was expected, has long since beenreached in the case o most loan pools.
Lee, Mayer, and racy (2012) oer 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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