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Legal Studies Paper No.

2008-28 September 2008

Stabilize Home Mortgage Borrowers, and the Financial System Will Follow

Professor Lauren E. Willis

Electronic copy available at: http://ssrn.com/abstract=1273268

Stabilize Home Mortgage Borrowers, and the Financial System Will Follow Lauren E. Willis* Sept. 24, 2008 To halt the Great Depression, the federal government nullified all clauses in contracts that pegged debt to the price of gold. By taking these contracts off the gold standard, debts were reduced by roughly 40 percent. Economist Randall Kroszner, now a governor on the Federal Reserve Board, examined the effects of this sweeping debt reduction and found that both stocks and bonds responded favorably. Investors and creditors decided that the elimination of debt overhang and the avoidance of threatened corporate bankruptcies more than offset the cost to creditors of receiving 60 cents on the dollar. And the taxpayer did not pay a penny. This trick could only be performed once, now that gold clauses are out. So is there a way to eliminate todays mortgage debt overhang, staunch foreclosures, and restore liquidity and stability in our financial markets? Yes. We have not yet used our most potent weapon against the crisis: eminent domain. Eminent domain is the power of government to take private property for a public purpose, so long as the owner is paid just compensation. Eminent domain can be used to correct deficiencies in the market, particularly when they threaten public tranquility and welfare. The property hazards, fires, crime, and other social costs imposed by foreclosures will threaten our nations tranquility and welfare until foreclosures are dramatically reduced. Families will continue to be uprooted and their children moved from school to school, disruptions that impose intangible and long term costs on society. We can not directly devalue loan contracts to reduce our excessive mortgage debt, but we can use eminent domain. How would this work? Upon petition of the homeowners, the government would take primary residences at risk of foreclosure and then sell the homes back to the homeowners at current market prices. Because just compensation in eminent domain is measured by the market value of the property, todays fire-sale home prices would be a boon to this plan. Lenders and investors would receive the lesser of the mortgage balance or the amount paid by the government as just compensation. Unlike newly-invented securities and other financial instruments, homes have been appraised for a very long time and objective criteria can establish market value. For homeowners with mortgages that are underwater, the effect would mirror the debt reduction achieved when Congress nullified the gold clauses. Home values would bottom out quickly, and households looking to buy would see lower house prices. For families that can not afford a mortgage even with a balance reduced to market price, the seized homes could be sold to investors that commit to renting back to the homeowners.

Associate Professor of Law, Loyola Law School Los Angeles.

Electronic copy available at: http://ssrn.com/abstract=1273268

For housing that has already been abandoned, streamlined procedures should be put in place to take the homes by eminent domain, repair them if possible and raze them if necessary, and then sell the properties to new owners. While some commentators seem to think that the $700 billion bailout is going to provide homeowners with a kinder, gentler federal government lender, the bailout primarily contemplates buying not individual mortgages, but shares of securities backed by pools of mortgages and other complex financial instruments. Unless the government buys all the shares in a poolan unlikely proposition given that owners are spread around the globeit will lack authority to do workouts with homeowners whose mortgages are in the pool. The thousands of families falling into foreclosure and bankruptcy each day will continue for years, with the limited capacity of loan servicers and courts prolonging the problem. The social costs of foreclosure will roll on, increasing the tax burdens and decreasing the quality of life for all households, renter, former homeowner and current homeowner alike. Eminent domain has the virtues of the Wall Street bailout plan without the vices. Financial firms and other investors could no longer delay realizing losses on their mortgage backed securities and similar financial assets, but simultaneously would bring in cash from mortgage prepayments, pumping liquidity back into the financial system. Taxpayer money would not be spent overpaying Wall Street for their complex financial instruments, and the underlying mortgage debt overhang problem would be addressed. This is not to say that this plan is cost-free. But $700 billion amounts to over $140,000 apiece for the approximately 5 million mortgages expected to go into foreclosure in the next three years, or over $13,000 apiece for all 53 million mortgages in the U.S. currently outstanding. For the government to buy homes at risk of foreclosure at market prices and sell them back to households, underwrite and originate mortgages to those households, and then sell these mortgages will cost far less than this. So long as the government underwrites the mortgages well, with documentation of borrower income and assets, fair appraisals and monthly payments the borrowers can afford, banks and investors will buy them. This plan is not entirely unprecedented; eminent domain has been used to boost homeownership in the U.S. before. At one time in Hawaii, concentrated land ownership was injuring the public tranquility and welfare by preventing ordinary families from owning the property on which they lived. To fix this market failure, the state took land from large landowners and compensated them at fair market value. The state then sold the property to the families who had been living there and paying rent, offering them mortgages through the Hawaii Housing Authority. As the Wall Street bailout plan recognizes, a crisis that sweeps the country requires a solution of like scope. Like the abrogation of the gold standard clauses, eminent domain is a blunt instrument, one that inevitably will be overly generous to some and will hurt others. But hurting the ordinary taxpayer to be overly generous to well-heeled banks and other sophisticated investors, without even addressing the underlying mortgage debt overhang and foreclosures, is not the answer. Eminent domain would stabilize Main Street and Wall Street.

Electronic copy available at: http://ssrn.com/abstract=1273268