Using Eminent Domain to Condemn Mortgages

The New York Times has an interesting article describing one California city’s plan to use eminent domain to condemn and restructure mortgages [HT: numerous readers who have written me requesting that I do a post about this issue]:

The power of eminent domain has traditionally worked against homeowners, who can be forced to sell their property to make way for a new highway or shopping mall. But now the working-class city of Richmond, Calif., hopes to use the same legal tool to help people stay right where they are.

Scarcely touched by the nation’s housing recovery and tired of waiting for federal help, Richmond is about to become the first city in the nation to try eminent domain as a way to stop foreclosures…

Richmond is offering to buy both current and delinquent loans. To defend against the charge that irresponsible homeowners who used their homes as A.T.M.’s are being helped at the expense of investors, the first pool of 626 loans does not include any homes with large second mortgages, said Steven M. Gluckstern, the chairman of Mortgage Resolution Partners.

The city is offering to buy the loans at what it considers the fair market value. In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default.

Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program. The $30,000 difference goes to the city, the investors who put up the money to buy the loan, closing costs and M.R.P. The homeowner would go from owing twice what the home is worth to having $10,000 in equity.

This use of eminent domain might well be legal under California’s fairly permissive eminent domain laws. And it would almost certainly pass muster under the Supreme Court’s interpretation of the federal Constitution in Kelo v. City of New London, which allow the government to use eminent domain for almost any “public purpose” that isn’t “pretextual.” Unlike many other uses of eminent domain, such as that in Kelo itself, this one at least doesn’t destroy any valuable property on the mere promise that the new owners will use the land better. At least in the short run, this condemnation is pure redistribution of wealth without any destruction. The houses in question remain where they are, untouched, but most of their value is transferred from the lenders to the borrowers.

Nonetheless, this superficially attractive proposal is ultimately a bad idea. Much of the appeal of it is populist: it seems to reward poor homeowners at the expense of wealthy banks and investors. In reality, however, this is upward redistribution as much as downward. The money to purchase the mortgages will come from taxpayers, including the poor. And most of the really poor people in our society (including in cities like Richmond) are not homeowners at all, and therefore won’t benefit from this program. They’re renters. You might argue that renters at least won’t be paying to subsidize the program, since local government is funded primarily through property taxes. But renters do pay property taxes indirectly, since the rent they pay is in part determined by the property taxes paid by their landlords. People in the bottom 20% of the American income distribution usually either rent or own homes that don’t have mortgages at all. Renters and the poor already indirectly subsidize comparatively affluent homeowners through policies such as the mortgage interest deduction. We should not impose additional burdens of this type on them.

In addition to redistributing wealth from the poor to the relatively affluent, the Richmond program also benefits those who took dangerous risks at the expense of the prudent. Many people with underwater mortgages got into that fix because they purchased homes in the midst of a real estate bubble, and the mortgage exceeded their income to such an extent that they could only afford to pay it if real estate values kept going up or at least didn’t fall. But long experience shows that rapid increases in real estate prices are often followed by falls. It’s understandable that some people decided to take the risk anyway, and their decision to do so wasn’t always irrational. But it isn’t good policy to force more prudent homeowners to subsidize such behavior. Doing so will predictably incentivize more dubious risk-taking in the future.

Relatively prudent Richmonders will also lose out from this policy in another way. If lenders believe that, in any future downturn in real estate prices, the city is likely to condemn mortgages and force them to accept far less value than they could get from a foreclosure, they are likely to either be unwilling to lend to future home purchasers in the city, or only do so at relatively high interest rates to make up for the risk of condemnation.

It’s also worth noting that one of the justifications Richmond officials offer for this policy is the fact that home values in the city remain low. That’s unfortunate for present homeowners there. But it also means that residents whose homes get foreclosed on can more easily find new homes in the area at low prices. That should diminish the pain they suffer as a result of the downturn in the housing market, and their own risk-taking behavior. Too often, we ignore the fact that low real estate prices are bad for current property owners, but a boon to potential homebuyers and renters.

Finally, we should remember that the power of eminent domain is often used to benefit the politically powerful at the expense of the poor and the weak. For reasons described above, even this case is an example of that phenomenon, though more ambiguously than many others. If we allow these types of takings, we open the door that much wider for future Kelos and Poletowns. We should instead be working towards a regime under which all property rights will have greater security against takings. That’s an essential step towards promoting the kind of economic development that can truly uplift the poor.

UPDATE: Some people might defend this use of eminent domain as a response to an unusual crisis, that is unlikely to ever be repeated in the future. However, the history of expansions of government power strongly suggests that it is unlikely we can confine them in that way. That is certainly true of the history of eminent domain. For example, “blight” condemnations were originally justified in the 1930s as a way to clean up terrible “slums” during the Great Depression. Over time, however, the definition of “blight” gradually expanded to the point where almost any property can be defined as blighted or condemned. Similarly, policies like this one could easily be applied any time a downturn in the real estate market leaves some substantial number of mortgages underwater.