by Robert Hockett, Federal Reserve Bank of New York
In the view of 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 of privately securitized mortgages, such write-downs are almost impossible to carry out, since loan modifications on the scale necessitated by the housing market crash would require collective action by a multitude of geographically dispersed security holders. The solution, this study suggests, is for 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 of security holders.
It is now more than six years since U.S. residential real estate prices peaked and then plunged. Prices dropped nationally by 35 percent and still linger close to 30 percent below peak levels. In harder-hit communities, prices are considerably more than 50 percent below peak.1 While cyclical fluctuations push prices up for brief periods, no consistent upward trend has been firmly established (Chart 1). Indeed, the highest post-bubble price peak prior to March 2013 came not last year or the year before but in July 2010, while early 2012 saw the deepest post-bubble trough since April 2009. Prices reached a seasonal peak in September 2012, then leveled off through February 2013. These fluctuations, highlighted in the moving average change measure in Chart 1, have been the pattern in home prices since 2009.
While home prices—and hence home equity values—have fallen and remain low, the fixed debt obligations that buyers had to take on to purchase homes under bubble conditions have not. Consequently, approximately 11 million homes, or slightly less than a quarter of all homes with mortgages outstanding, are “underwater”—meaning that the balance on the mortgage exceeds the current market value of the home. Of these mortgages, between 3 million and 4 million are in default, in foreclosure, or foreclosed and awaiting liquidation. Over 2 million more are seriously delinquent—two-to-four payments in arrears (Olick 2012; Goodman et al. 2012; Ritholtz 2012; Goodman 2012).
Recognizing that defaults and foreclosures take a toll on the economic welfare of communities and the nation as a whole, many analysts have called for the write-down of principal on mortgage debt as the most effective solution to the problem of underwater mortgages. As these analysts attest, write-downs have the important advantage of raising value.
However, the difficulty lies in carrying out the write-downs. While principal reduction on mortgages held in bank portfolios occurs at significant and still growing rates, loans held in private-label securitization (PLS) trusts have certain structural features that make such reductions very rare. Specifically, these loans are subject to pooling and servicing agreements that would require collective action by a large majority of security holders before the loans could be modified or sold out of trusts. Conducting such a collective action across most holders of the securitized loans would be nearly impossible.
This edition of Current Issues puts forward a strategy for carrying out the write-downs. Essentially, it recommends that state and municipal governments use their eminent domain powers to address the collective action problems that now prevent the write-down of privately securitized loans. Under eminent domain, these governments can step in to purchase underwater loans at fair value, deal directly with the trustees of the private-label securitization trusts, and sidestep the rigidities of the pooling and servicing agreements. They can then reduce the principal on these loans, lowering the “water” and thereby reducing the risk of default.
The Mortgage Debt Overhang: Scope of the Problem
Fewer than half of the nation’s roughly 11 million underwater mortgages are current, and large numbers of these mortgages go delinquent each month:2 Together with loans that are already delinquent or in default, 7.5 to 9.5 million additional homes are expected to go into liquidation over the next several years absent remedial action.3 These liquidations would further burden an already depressed market, yielding a backlog of vacant homes equal to 200 percent of U.S. annual home sales at the current sales pace (Olick 2012; Goodman et al. 2012; Ritholtz 2012; Goodman 2012).
For communities, the fallout from these developments is substantial, with residents forced to give up their homes and property tax bases weakened—ironically, just as abatement costs wrought by abandoned properties rise (Hockett 2012a). Other homeowners lose neighbors and endure the blight and lost value associated with boarded-up neighboring homes. Over time, they may see city services cut, school districts retrenching, and local economies shrinking—an aggregate monetized loss now estimated at $2 trillion (Hockett 2012a; Shoen 2012). Though causality is doubtless complex, the fact that so many counties have been filing for bankruptcy of late seems unsurprising against this backdrop (Church et al. 2012).
The mortgage debt overhang undermines the health of the national economy as well. Defaults and foreclosures in the housing markets feed back into the macroeconomy through effects upon net worth and spending (Federal Reserve Board 2012; Dudley 2012). And as reduced spending lowers growth and employment, more mortgages are drawn into foreclosure (Federal Reserve Board 2012; Dudley 2012; Hockett 2012a, 2012b). Hence the familiar “holding pattern” of high under-water loan and foreclosure rates yielding low growth and employment, which in turn yield yet more default and fore-closure, and so on (Hockett 2012a, 2012b, 2013).4
