c u r r e n t i s s u e s
F E D E R A L R E S E R V E B A N K O F N E W Y O R K
i n E c o n o m i c s a n d F i n a n c E
V o l u m e 1 9 , N u m b e r 5
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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 modications 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.
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While cyclical uctuations 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 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 o through February 2013. Tese uctuations, 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 deault, 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).
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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 FINANCE
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Volume 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 o underwater mortgages. As these analysts attest, write-downshave the important advantage o
raising
value.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 inprivate-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 security holders 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 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 deault.
Te Mortgage Debt Overhang: Scope o the Problem
Fewer than hal o the nation’s roughly 11 million underwatermortgages are current, and large numbers o these mortgagesgo delinquent each month:
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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.
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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. 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 andemployment, which in turn yield yet more deault and ore-closure, and so on (Hockett 2012a, 2012b, 2013).
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Te Prudent Solution: Scaled Principal Write-Downs
Te most eective means o averting mortgage delinquency,deault, and oreclosure—and the associated economiccosts—is principal reduction. As even creditors recognize,
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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.
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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.
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O course not all mortgage troubles are attributable to declining home values.Some homeowners ace diculty 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, 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 nation’s larger mortgage debt overhang problem will remainunaddressed (Campbell and Hockett 2012a, 2012b).
-3.0-2.5-2.0-1.5-1.0-0.500.51.01.52.01251351451551651751851952052152253-month moving averagechange in HPI20-city composite HPI 20122011201020092008 20072006
Source: Standard & Poor’s/Case-Shiller Home Price Index (HPI).
Percent
Trends in Home Prices: July 2006–March 2013
Based on the Twenty-City Composite Case-Shiller Home Price Index
Case-Shiller HPI
ScaleScale
debt
loss must be ormally recognized in a manner that bearssome intelligible relation to home
equity
loss. Moreover, ormuch underwater mortgage debt, write-downs raise value—abenet borne out by the requency with which portolio 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 portolios 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 loans—eaturesthat now act as market ailures—prevent the rational thingrom 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, 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, o course, and probably thereore keeps modication rates lowerthan optimal even among banks. But in the case o privately securitized 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 loans—agreements draed 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 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 addresstheir collective action problems, rom modiying or sellingo loans in the requisite numbers (Hockett 2012a, 2012b).
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Finally, 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 many underwater 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 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).
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Inaddition, the second lienholders quite oen are banks—thesame 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 constraints—including inapplicable bankruptcy laws and Internal Revenue Code and rust Indenture Actuncertainties—impede 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 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 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. 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
which
govern-ment should take up this mantle—ederal, state, or local?
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In some cases, or example, pooling and servicing agreements allow no morethan 5
percent o the loans in the pool to be modied. Tis
percentage, whichshows how little the marketwide crash was expected, has long since beenreached in the case o most loan pools.
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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.
www.newyorked.org/research/current_issues
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