Richmond, Calif., is sending shockwaves through the financial industry with a bold strategy to resolve its ongoing housing crisis. A city of about 100,000 people on the outer shores of San Francisco Bay, Richmond has been left behind by the economic recovery. Roughly half the home mortgages there are underwater and many are worth less than half of what is owed on them. Vacant and foreclosed properties blight the city, a largely black and Hispanic community.
Banks have dragged their feet in restructuring the underwater mortgages. So this week, Richmond invoked the threat of eminent domain to break the deadlock. The city wrote to 32 lenders offering to buy 624 homes at prices close to current market value, but far less than the outstanding loans. This would force the lenders to write off the balance as a loss. The city is threatening to use eminent domain to take possession of the loans and the homes if the banks don't accept the city's offer or negotiate a mutually acceptable counter-offer.
Once the city has bought the homes – whether by agreement or through eminent domain – it plans to restructure the mortgages so the present occupants can stay in them. The loans will be reset to a price close to current market value, and the payments will be reduced accordingly. Homeowners, instead of being underwater, will now have a small amount of equity in the property. They will have both the means and the incentive to stay current on the loan going forward.
Not surprisingly, the banking and real estate industry is vigorously fighting the use of eminent domain to force mortgage resolution. Industry spokespeople say that governments have no right to step into a private transaction between a borrower and lender. They're lobbying the cities involved, threatening to raise interest rates for any city that allows eminent domain to be used this way and promoting legislation that would bar Fannie and Freddie from supporting loans made in jurisdictions that use eminent domain.
But objectively, it's hard to see why bailing out homeowners with a program of this sort is any less an affront to the principles of capitalism than bailing out banks that made bad investments in mortgage backed derivatives.
Both sides have a point. If eminent domain were used too freely, it would in effect give borrowers a "get out of jail free" card that would encourage unhealthy speculation. It would also shift the economics for lenders, raising the cost of credit.
On the other hand, the present situation is bad for communities, bad for borrowers and, frankly, it's bad for many lenders. It's bad for communities because the presence of foreclosed homes depresses property values, cuts tax revenues, and attracts vandalism and crime. It's bad for borrowers because a motivated borrower who could keep up with a restructured and realistic payment stream loses the ability to keep his house, build some equity and maintain a good credit rating. It's bad for most lenders because if loans like these aren't restructured they usually default, and then the losses due to legal fees, vacancies, carrying costs and transaction costs can easily exceed what would have been lost by modifying the loan.
Eminent domain can be a powerful tool for leveling the playing field between borrowers and lenders. Right now, it's almost impossible for a homeowner to gain any leverage in negotiating with a lender. The lender has vast legal resources, and time is on their side. So it makes for a more productive and fair negotiation if a city or other entity can step in, aggregate multiple distressed homeowners and negotiate on their behalf. This way, both lender and borrower have a strong incentive to negotiate, and this helps get a deal done that saves money for most of the stakeholders.
But while eminent domain has an important place in the toolkit, some safeguards and limits must be imposed to avoid encouraging more bad loans.
- Eminent domain as a lever makes sense when the number of foreclosed homes in an area reaches the level where it causes major community problems, blighting the neighborhood, increasing crime, eroding the tax base and so on.
- The threat of eminent domain makes sense after a good faith effort has been made to restructure the underwater and non-performing mortgages and yet no progress is being made.
- Actions based on eminent domain need limits on the kind of borrower who can participate – for example, owner occupiers should be allowed, but not those who buy and flip multiple properties on speculation.
- Eminent domain is more justifiable in cases where there's evidence of malfeasance on the lenders' part, for example steering borrowers into a product they clearly couldn't afford, or steering them into a higher priced loan than their credit rating would warrant. In this case, Caveat Emptor applies to the lender as well as the borrower.
This will be a closely watched case, with many cities in similar situations. We need a better solution for those who have been left behind by the recovery in housing prices.
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