"We Don't Follow, We Lead": How New York City Will Save Mortgage Loans by Condemning Them
Many cities across the nation have begun to consider exercising their eminent domain authority to purchase, then write-down principal on, otherwise unmodifiable home mortgage loans facing foreclosure.2 I and several others have advocated this method and cognate uses of government authority to stabilize troubled housing markets for some years now,3 but the eminent domain approach to the problem nevertheless remains unfamiliar to many people. This is likely to change in the coming months. I recently joined New York City Council members on the steps of New York City Hall as they announced their intention to embrace some version of the eminent domain plan to address the City’s negative equity challenges.4 If they and fellow Council Members follow through on that intention, then many more Americans are likely to hear about the plan. This plan calls for cities to purchase “underwater” mortgage loans out of securitization trusts in order to prevent foreclosures, stabilize communities, and benefit (or avoid harming) mortgage investors in the process.5
In this Essay I hope to explain why the eminent domain plan is necessary in New York and other cities, how the plan works, and why it is sound as a matter of law and policy. Part I addresses the plan’s necessity. Part II covers the plan’s basic mechanics. Part III discusses the plan’s legal grounding and policy propriety. Part IV concludes.
The necessity of the eminent domain approach to underwater home mortgage debt rests on two facts. The first is that principal—that is, the base amount owed—on underwater home mortgage loans must be written down in order to prevent default, foreclosure, and consequent neighborhood blight. The second is that, for a large fraction of underwater loans, eminent domain is the only way to access the loans so as to write down the debt. I explain both points below.
Twenty percent of the nation’s outstanding mortgage loans remain deeply underwater, meaning that borrowers owe significantly more on these loans than the homes that they purchased with the loans are now worth.6 This is true despite the fact that the national housing price crash began more than seven years ago. Moreover, because underwater loans are heavily concentrated in low-to-middle income neighborhoods and communities of color, many American cities suffer underwater mortgage loan rates near or above 50%.7
Although unique in many respects, New York City has not escaped the negative equity problem. Manhattan fares well, but the other four boroughs do not. According to a June 2014 report by New York Communities for Change and the Mutual Housing Association of New York, 60,000 NYC home-owning families have underwater loans, and this constitutes 12% of total outstanding NYC mortgage loans.8 As elsewhere in the nation, communities of color are disproportionately represented in these statistics.9
One notable reason why such numbers are worrying is thatdeeply underwater loans have an approximately 70% chance of defaulting and ultimately going into foreclosure.10 This means there is an approximately 70% chance that the borrowers on these loans will lose their homes; that the lenders on the loans will lose their investments and incur millions of dollars in loan losses and foreclosure costs; that the borrowers’ neighbors will undergo neighborhood blight and gaping property value losses; and that the cities in which the blighted neighborhoods are located will incur onerous property abatement costs even as property tax bases precipitously decline.11 Moreover, reduced spending by underwater homeowners is likely to affect local economies.12 Such far-reaching effects mean that when underwater loans can be written down, they typically are written down, because doing so benefits all stakeholders.13 The problem is that most underwater mortgage loans cannot currently be written down, and this provides an impetus for the eminent domain plan.
There are several reasons that underwater mortgage loans cannot typically be voluntarily written down. Most stem from the complex legal and financial structures developed by the private mortgage lending industry during the recent housing price bubble.14
The principal relevant structure is that of the private-label securitized (PLS) mortgage loan.15 Pursuant to this structure, loans, once extended, are pooled into a legal trust managed by a trustee. The trustee ensures that loan servicers collect monthly mortgage payments from borrowers, which the trustee then disburses to the investors—typically bondholders—who supplied the initial funds used to purchase the loans pooled in the trust.16 This structure thus interposes a middleman—the trust—between the borrower (the homeowner) and the creditor (the bondholder). As a result, the creditor and debtor cannot voluntarily work out a principal write-down on an underwater mortgage loan even when doing so would be mutually beneficial.
This write-down problem could have been avoided had the contracts pursuant to which mortgage loans were pooled and securitized during the housing bubble years provided for large-scale principal write-downs by trustees or servicers in the event of a housing price crash. Unfortunately, they did not.17 The securitization industry apparently did not anticipate a nationwide housing price crash of the scale that occurred. Like many others, individuals in the industry seem to have believed that housing prices could only go up.18And unfortunately, creditors are too geoally scattered to come together to amend the contracts in order to authorize trustees or servicers to modify more underwater loans than they are presently authorized to do.19In consequence, mortgage loan securitization contracts now function as unintended “suicide pacts” among creditors.20
The situation is tragic in the classical Greek sense of the word: everyone loses, but no interested party is able to change things. Only a party empowered to act on behalf of all interested parties—in the present case, a governmental authority—is able to end the tragedy and solve the problem for all.21
The eminent domain plan would solve the underwater mortgage loan and associated foreclosure problem by substituting a governmental authority, which has the power to amend dysfunctional contracts, for the powerless middleman—that is, the loan servicer or securitization trustee. The governmental authority would thereby enable the homeowner and bondholder to do for themselves what contract-bound trustees and servicers cannot do for either: rewrite underwater mortgage loans in a manner that salvages value for both, maintaining homeownership and rescuing communities in the process.22
The key move in the eminent domain plan is for the governmental authority to purchase underwater loans out of the legal trusts in which the loans are presently locked.23 Once the loans are out of the pool and no longer subject to the modification restrictions imposed by the current securitization contract, they can be modified in a manner that benefits homeowner, bondholder, and community alike.24 The modified loans then can be re-conveyed to the bondholders, who supply the funds used by the governmental authority to purchase the loans that are to be modified on their behalf and on behalf of the homeowners. This will leave bondholders with more valuable assets than they had before, since they are now more or less free of default risk, and will leave homeowners with positive equity in their homes. It will also, for the reasons noted above, benefit neighbors, municipalities, and local economies.25
Because New York and other cities bear the brunt of the nation’s ongoing underwater mortgage loan troubles, cities are well-situated to act as the governmental authorities just noted.26 In particular, cities with significant concentrations of underwater mortgage loans in specific neighborhoods or zip code areas will have both the greatest reason to adopt the plan and the greatest justification to pursue it, since such areas are most vulnerable to foreclosure-led blight of the sort that tends to prompt and warrant legal use of the eminent domain power.27 To adopt the plan in a legal manner, cities must satisfy two requirements: first, they must provide a public purpose for exercising their eminent domain authority; second, they must pay fair value for the loans they purchase from trusts.28
Because current bondholders benefit from loan write-downs, these bondholders, supplemented if necessary by federal funds, nonprofits, and other investors, have reason to supply the funds necessary to pay “fair value.”29 Moreover, because modifying mortgages will allow cities both to end their foreclosure and homelessness crises and to reverse neighborhood blight—arguably the most well established “public purpose” to justify the use of eminent domain authority—the cities will likely satisfy the “public purpose” requirement.30
The following diagram represents the foregoing description of the eminent domain plan pictorially, starting from the upper left and following the single-headed arrows counterclockwise.31
Following the arrows, current bondholders convey funds to eminent domain trusts established and managed by cities or by the joint powers authorities (JPAs) that they have established. The trusts then purchase deeply underwater (in the diagram, “bad”) loans out of current PLS trusts. Following this, the cities, advised if necessary by the Federal Housing Agency (FHA) or legal and financial professionals, work with homeowners to write new mortgages, allowing borrowers to replace their current negative equity loans with new, modestly positive ones.32Finally, the new (in the diagram, “good”) loans are conveyed to city-established trusts, which distribute monthly loan payments to all parties (including current bondholders) that have worked with the cities to supply the funds used to purchase the “bad” loans out of the original trusts.
The diagram represents merely the basic structure of the plan. Additional details of the plan as adopted by various cities will be determined by those cities themselves as they develop their own variants.33 These questions include (a) how to select and appraise the fair values of qualifying loans;34 (b) how to approach current bondholders and other investors, as well as federal agencies offering assistance to foreclosure-plagued cities;35 (c) how to commence and carry out the legal proceedings pursuant to which local eminent domain authority is exercised;36 (d) how to modify and then re-securitize qualifying loans once purchased; (e) how to approach and work with homeowners throughout the process;37 and (f) how to compensate current bondholders and other investors at appropriate stages.
These questions can be addressed in many different ways, as I have detailed elsewhere.38 For example, New York City might combine its version of the program with a land bank program for already-foreclosed homes, as I have recommended to other cities such as Seattle.39 In this Essay, however, I limit myself to conveying only the fundamentals of the plan.
Although the eminent domain plan appears to be a “win-win,” some have argued against it. In this Part, I describe the arguments of those who do not favor the plan and highlight the inadequacies of these views.
First, some opponents of the plan argue that purchasing local loans through eminent domain would violate the Contract Clause of the U.S. Constitution.40 But the Supreme Court, in its leading and most recent decision interpreting the Contract Clause, unanimously ruled out the Clause’s applicability to exercises of eminent domain. In Hawaii Housing Authority v. Midkiff, the Court held that “the Contract Clause has never been thought to protect against the exercise of the power of eminent domain.”41 City attorneys, therefore, should not be fazed if faced with Contract Clause arguments raised by objectors to the eminent domain plan.42
Some opponents of the eminent domain plan also argue that the loans that cities would purchase pursuant to the plan would be legally located outside those cities and accordingly outside their jurisdiction.43 In consequence, the opponents continue, cities’ exercising their eminent domain authority over the loans would violate the Due Process Clause of the U.S. Constitution.44Supreme Court and other court decisions that apply to debt instruments, however, indicate that loans are, in general, legally located where borrowers are domiciled,45 while mortgageloansin particular are legally located where the mortgaged properties securing the loans are located.46 In the case of home mortgage loans, of course, both standards converge on the same result. New York City home mortgage loans are legally located in and subject to the jurisdiction of New York; San Francisco home mortgage loans are legally located in and subject to the jurisdiction of California; and so on.47
Some opponents of the plan also argue that municipal use of eminent domain would violate the Dormant Commerce Clause by (a) regulating loans located outside of city limits, (b) discriminating against out-of-state financiers, and (c) unnecessarily burdening interstate commerce.48 As noted above, however, under applicable precedent the loans are legally located in the cities that will be taking them in eminent domain. The cities, moreover, will not be engaging in regulation, let alone regulating out-of-state creditors differently than in-state creditors or otherwise burdening commerce, as a Commerce Clause violation would require.49 Indeed, given the drag that unmodifiable toxic loans impose upon mortgage markets, clearing such loans out of PLS trusts would actually enable commerce.50
Another set of legal arguments proffered against the eminent domain plan is that there cannot be any public purpose in having a city purchase underwater mortgage loans and that it is not possible for the cities to pay fair value for the loans—both of which the U.S. and all state constitutions require of government takings.51 But as noted in Part II, rescuing a local community from blight, crime, municipal bankruptcy, and other ravages wrought by thousands of deeply underwater home mortgage loans is an established public purpose under both federal and most state court precedent.52 Furthermore, courts generally accept a community’s determination of public purpose as long as it bears a rational relation to a conceivable public purpose.53
As for whether it is possible to pay fair value for the loans, it is not only possible to pay the full value of the loans as noted in Part III, it is also constitutionally required to do so under both federal and state law. The eminent domain plan provides for full value to be paid, as discussed in Part II.
Some industry representatives make the policy argument that use of the eminent domain authority to address the underwater mortgage loan crisis will set us on a slippery slope at the bottom of which cities exercise the eminent domain power much too broadly.54 History, however, does not support this claim. The eminent domain authority has already been used in this nation for centuries to purchase many intangible assets, including railroad stocks, mortgage liens, insurance policies, bond covenants, and even sports franchises and going concern values of firms.55 This point seems to be little-known, and this may arguably be evidence that such uses of eminent domain authority have natural legal limits and do not result in government overreach.
Another policy argument made by some members of the securitization industry is that using eminent domain to purchase loans will dry up the sources of mortgage credit, rendering the American dream of homeownership unattainable.56 The financial services industry and its legislative supporters have made this kind of claim against regulatory and consumer protection proposals emerging from national, state, or municipal legislatures.57
One problem with this argument is that private credit has not flowed to non-wealthy mortgage borrowers since the crash. Federal lenders and guarantors are nearly the only game in town, and they are likely to remain so until the underwater PLS loan logjam is cleared.58
Another problem with the credit withdrawal argument is that it characterizes a benefit as a burden. The housing bubble was, like most of the more devastating bubbles through history, the upshot of an over-extension of credit.59 Lenders extended excess credit through reverse redlining and other predatory lending practices perpetrated or aided and abetted by participants in the securitization industry itself.60 Hence the securitization industry’s warning61 that credit might not be overextended in the future is a warning of something that might well be desirable.
A third policy argument proffered by industry opponents of the eminent domain plan is that embarking on the plan will confront municipalities with “costly and lengthy litigation.”62 This claim is a bit like the credit withdrawal argument in that it purports to be a prediction when in fact it is a threat. Fortunately, as with credit withdrawal, the threat is an idle one.
First, as soon as the first cities begin to condemn loans pursuant to the eminent domain plan and secure rapid dismissals of industry group suits—as Richmond, California did to two suits merely days after they were filed in the summer of 201363—groups that sue are likely to find few followers. Second, regional offices of the American Civil Liberties Union (ACLU) have already begun supporting cities in their eminent domain plans, meaning that cities need not fret that the “endless litigation” will be expensive to them.64Indeed, in light of both the weakness of opponents’ likely legal arguments and the support that the cities now have from the ACLU, it would seem that would-be plaintiffs are the ones who face the prospect of exorbitant legal expenses incurred for no appreciable purpose.
From the summer of 2012 to the summer of 2013, some securitization industry groups succeeded in obtaining the sympathetic ear of then-Acting Director of the Federal Housing Finance Agency (FHFA) Edward DeMarco.65 DeMarco was widely known to object to mortgage loan principal reductions of any sort on ideological grounds.66 He rejected reductions for the portfolios that the FHFA controlled even after learning from FHFA economists that principal write-downs on underwater loans in the Fannie and Freddie portfolios would save those agencies 1.7 billion dollars in otherwise inevitable default and foreclosure expenses.67 DeMarco nevertheless issued vague warnings that the FHFA might intervene in its capacity as conservator for Fannie and Freddie against cities that employed the eminent domain plan.68 Industry groups used DeMarco’s statement to claim that the federal government opposed the eminent domain plan.69
It would not, however, have been within the FHFA’s legal authority to do what DeMarco suggested.70 Moreover, the ACLU and I were prepared to challenge the FHFA on behalf of cities pursuing eminent domain solutions.71 In consequence, the FHFA did little more than solicit public comment on the advisability of the eminent domain plan. And DeMarco was finally replaced earlier this year by a new permanent Director who favors principal reductions for underwater mortgage loans.72 Finally, the “feds are against it” claim has never applied to any of the other federal instrumentalities with an interest in the nation’s ongoing mortgage troubles, which can plausibly be thought to (a) favor principal reduction for underwater mortgage loans, and (b) maintain that municipal uses of the eminent domain authority for this purpose are essentially local matters in which the federal government should not intervene.73
The eminent domain approach to underwater home mortgage debt is urgently needed in many of the nation’s hard-hit cities, including New York, and—I have argued—the principal legal or policy arguments made against implementing it lack plausibility.
The multitude of cities now studying or actively pursuing the plan offers evidence of its viability. We can accordingly expect more cities to act on the plan going forward. If New York now acts to lead this movement, as it well might,74 one dares predict that many more cities will follow.
Robert Hockett is Edward Cornell Professor of Law, Cornell Law School; Fellow, The Century Foundation. He is an originator of the eminent domain approach to securitized underwater mortgage loans and a regular consultant on mortgage, finance-regulatory, and related matters to a variety of federal, state and local government legislators and regulators as well as finance-concerned NGOs including Americans for Financial Reform and Public Citizen. This work is gratis, and he is not in any way financially invested in the eminent domain plan.
Preferred Citation: Robert Hockett, “We Don’t Follow, We Lead”: How New York City Will Save Mortgage Loans by Condemning Them, 124 Yale L.J. F. 131 (2014), http://www.yalelawjournal.org/forum/mortgage-loans-and-eminent-domain.html.