Saving Homeowners By Letting Them Go Bankrupt

The federal government should give mayors and underwater homeowners a better tool to save troubled neighborhoods.

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FILE - In this April 4, 2010 file photo, a forclosure sign tops the for sale sign outside a home in Denver. Foreclosure activity jumped in 149 of the 206 largest metropolitan areas in the U.S. last year, foreclosure listing firm RealtyTrac Inc. said Thursday Jan. 27, 2011.

What's a mayor to do? For the mayor of Richmond, Calif., where about 50 percent of home mortgages are underwater, these are desperate times. Richmond is caught in a downward spiral. Underwater mortgages lead to abandoned houses, shrinking local taxes and services, which inevitably results in more abandoned houses. 

So Mayor Gale McLaughlin decided to team up with Mortgage Resolution Partners and use the powers of eminent domain to force banks to reduce the outstanding principal on some of these underwater mortgages. One problem with this plan, Nic Retsinas, Senior Lecturer at Harvard Business School and former Assistant Secretary for Housing at the Department of Housing and Urban Development, points out, is that "it helps the wrong people." Mortgage Resolution Partners wants to reduce the principal on the mortgages of those people who are up to date on their mortgage payments. While we might admire these people for continuing to meet their obligations, cherry-picking 624 families with the greatest financial capability hurts bond holders without really solving Richmond's problem.

The Federal Housing Finance Agency, the conservator for Fannie Mae and Freddie Mac, essentially quashed this plan by stating that it would instruct Fannie and Freddie to "limit, restrict or cease business activities" in any jurisdiction using eminent domain to seize mortgages. Since Fannie Mae and Freddie Mac currently guarantee about 93 percent of all home mortgages, any locality using eminent domain would shut itself off from the mortgage market, making it nearly impossible for any future home buyer to get a mortgage. According to National Mortgage News, "eminent domain is unlikely to proceed in light of FHFA's opposition."

[Read the U.S. News Debate: Should the Federal Government Provide Support to the Mortgage Market?]

If eminent domain, or even the threat of eminent domain, cannot help, are there alternatives? One alternative that has been talked about since the beginning of the housing crisis is reforming bankruptcy law so that judges have the power to restructure mortgages, including reducing the principal. I believe this idea merits serious reconsideration.

Bankruptcy laws are intended to give people a second chance. Unlike the Mortgage Resolution Partners' plan, the people who would benefit from a new bankruptcy law would be those who are desperate to save their home but cannot afford their current payments. Not everyone would get a reduced mortgage, because the bankruptcy judge would be obligated to ensure that all parties, especially creditors, are treated fairly. Moreover, a debtor in bankruptcy under this new framework would face significant consequences, unlike a debtor under the MRP plan.

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The headlines in the newspapers tout the fact that rising home prices are helping to alleviate the problem of underwater mortgages. However, according to CoreLogic, as of June 2013 there are still 9.7 million homes (19.8 percent of all homes with mortgages) where the outstanding mortgage is greater than the value of the house. Worse still, these homes are concentrated in specific neighborhoods where property values are recovering slowly, if at all. According to the Joint Center for Housing Studies in its State of the Nation's Housing 2013, "during the worst years of the housing downturn, 4,689 census tracts (the statistical equivalent of a neighborhood) had very high vacancy rates, with more than one in five homes unoccupied." These are the neighborhoods, like Richmond, where homeowners are deciding whether or not to abandon their homes and further add to the blight and distress.

The power of eminent domain comes from the Fifth Amendment to the U.S. Constitution. That FHFA would quash McLaughlin's attempt to use it, especially without extracting something in return, is surprising. For too long, the federal government has not partnered effectively with local governments in saving troubled neighborhoods. Eminent domain may be the wrong tool, but local governments have few other options. Rather than simply say no, maybe the federal government should give mayors and underwater homeowners a better tool – namely a revised bankruptcy law.

John H. Vogel Jr. is an adjunct professor at the Tuck School of Business.

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