Good for the Banks, Good for the Borrowers
By Lauren E. Willis, Professor of Law, Loyola Law School Los Angeles
February 17, 2012
Beginning in 2007, the federal government took drastic action to save the nation’s banks. The banks were underwater, with liabilities that exceeded assets by any honest accounting. In response, we committed to them not only $700 billion in much-ballyhooed TARP funds, but also, hidden from public view, trillions of dollars in loans at rates as low as .01 percent, far below what any private investor or bank would have given them.
Although the banks have made much of having paid back much (but not all) of the face value of TARP funds extended, they have not paid a market rate of interest on the money they borrowed. They have even kept what Bloomberg calculates to have been a neat $13 billion in profit from lending the money they borrowed back to American consumers and businesses at higher rates. The American people not only threw the banks a life raft, but pulled most of them ashore.
Yet over four years later, millions of American homeowners are still sinking. About twelve million homeowners are underwater, summing to the ironic number of about $700 billion. To avoid foreclosure, these homeowners will have to make, month after month, year after year, payments totaling far more than their homes are worth.
Many will not be successful. Best estimates are that if we stay on our present course, we are only half way through the foreclosures precipitated by dropping home values, and that the economy will remain in its feeble state for years. The social costs of foreclosure will roll on, increasing the tax burdens and decreasing the quality of life for all households, renter, former homeowner and current homeowner alike.
There is as yet no Troubled Asset Relief Program for homeowners, despite the Obama Administration’s many incarnations of its “Home Affordable” programs. Many Americans’ most troubled asset is their over-mortgaged home, and the government has neither committed $700 billion to help them, nor extended them .01 percent interest rate loans. The $17 billion in principal reductions just agreed to by the banks to settle charges that they lied to the courts in foreclosure documents and charged homeowners bogus fees is less than three percent of the total housing debt overhang.
But what was good for the banks would be good for homeowners, and for renters too.
How would a TARP for homeowners work? Through the power of eminent domain. Eminent domain allows the government to take private property for a public purpose, so long as the owner is paid just compensation. Eminent domain can be used to correct deficiencies in the market, particularly when they threaten public tranquility and welfare.
Homeowners trapped underwater threaten the welfare of our society. After sending inflated monthly payments off to banks, they have little left to spend each month in their communities. They cannot sell because they cannot afford to pay the mortgage balance that exceeds any price their houses could command. Stuck in place, they cannot move to cheaper housing, better jobs,
or training opportunities.
With so many Americans removed from the pool of potential buyers, those who own their homes with smaller mortgages or outright cannot sell their homes for decent prices, trapping them too in place and forcing some to delay retirement. The low house prices do not even benefit renters, who cannot easily buy – in communities that are not decimated by foreclosures, sellers cannot afford to sell, and in communities that are decimated by foreclosures, banks refuse to lend.
With everyone frozen where they were when the housing bubble burst, the workforce is not nimble enough to follow businesses that have quickly changing needs, and so American businesses outsource the work to companies in other countries – both to assemble products and to assemble the engineering teams to develop those products.
Eventually, underwater homeowners will have too little income to make their payments or will give up trying. Further foreclosures will not only drag housing prices down further, but lead to property hazards, fires, crime, and other social costs, threatening the nation’s tranquility.
The logistics of providing homeowners relief from their troubled assets are not particularly complex, and similar programs have been done before. Any jurisdiction with eminent domain authority – the federal government, state governments, or in some states, local government bodies – could do it.
Two general methods could be used, either triggered by a petition of the homeowner. One, which I first proposed in 2008, would allow the government to take primary residences at risk of foreclosure and then sell the homes back to the homeowners at current market prices, with new fixed rate mortgages that do not exceed the value of the home. Because just compensation in eminent domain is measured by the market value of the property, today’s fire-sale home prices would be a boon to this plan. Lenders and investors would receive the lesser of the mortgage balance or the amount paid by the government as just compensation.
A more elegant method, similar to one proposed by Professor Howell Jackson at Harvard Law School, would allow the government to take mortgages at risk of foreclosure, reduce the principal balances and renegotiate the terms with homeowners, without title to the home changing hands. The government would pay the lenders the market value of the mortgages, meaning what an investor today would pay for them; no investor would buy these mortgages for more than the value of the collateral securing them.
The government could sell the new or renegotiated mortgages to private investors directly or could sell bonds backed by the mortgages. So long as the government underwrites the mortgages well, with documentation of borrower income and assets, fair appraisals and monthly payments the borrowers can afford, banks and investors will buy the mortgages or bonds.
This plan is not entirely unprecedented; eminent domain has been used to boost homeownership in the U.S. before.
At one time in Hawaii, concentrated land ownership was injuring the public tranquility and welfare by preventing ordinary families from owning the property on which they lived. To fix this market failure, the state took land from large landowners and compensated them at fair market value. The state then sold the property to the families who had been living there and paying rent, offering them mortgages through the Hawaii Housing Authority. The Supreme Court had no trouble finding this to be constitutional.
Naysayers will predict that banks will never lend to homeowners again in any jurisdiction that implements this plan. But banks are not giving out many new mortgages now. A state or locality with homeowners that are no longer weighted down by excessive debt would be the best place in America to lend.
Others will say that forcing banks to realize the true deflated values of the mortgages on their books will send them back under. But history says otherwise. During the Great Depression, and against the strenuous objections and predictions of doom by creditors, the federal government nullified all clauses in contracts that pegged debt to the price of gold. By taking these contracts off the gold standard, debts were reduced by roughly 40 percent.
Economist and former Federal Reserve Board Governor Randall Kroszner examined the effects of this sweeping debt reduction and found that both stocks and bonds responded favorably. Despite their prior opposition, creditors decided that the elimination of debt overhang and the avoidance of threatened corporate bankruptcies more than offset the cost to creditors of receiving 60 cents on the dollar.
Like the abrogation of the gold standard clauses, eminent domain is a blunt instrument, one that inevitably will be more generous to some than others. Politicians may proclaim that irresponsible homeowners should not be given a helping hand. But in four years, underwater homeowners have already learned all they are going to learn, and to continue punishing them unfairly punishes the rest of us.
Now that we know the Wall Street bailout will not flow out to buoy up the rest of the country’s families and businesses, it is time to help ourselves.
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Lauren E. Willis is a Professor of Law at Loyola Law School Los Angeles, and an expert on the regulation of consumer financial products, including home mortgages.
Professor Willis earned her BA with high honors in general scholarship from Wesleyan University, and her JD, with distinction and Order of the Coif, from Stanford Law School where she was on the senior staff of the Stanford Law Review, a co-founder of the Stanford Public Interest Law Students Association, and a Foreign Language and Area Studies (Russian) Fellow. Lauren received the Block Civil Liberties Award, the Stanford Women Lawyers Scholarship, and the University Goldstein Award for Scholarship on Children at Risk.
After law school, Lauren clerked for the Office of the Solicitor General of the United States and for Judge Francis D. Murnaghan, Jr. of the United States Court of Appeals for the Fourth Circuit. Before coming to academia, Willis was a litigator in the Housing Section of the Civil Rights Division of the U.S. Department of Justice and worked with the U.S. Federal Trade Commission on predatory mortgage lending litigation. She currently serves on the Research Advisory Council of the Center for Responsible Lending in Washington, D.C.
Lauren taught at Stanford Law School as a Fellow, joined the Loyola faculty in 2004, and spent the 2008 Spring semester as a Visiting Associate Professor at the University of Pennsylvania Law School. She was honored by Loyola’s graduating day class with the 2008 Excellence in Teaching award.
In her lecture, panelist, and media appearances in the U.S., the E.U., Korea, and South Africa, Willis has discussed regulation of the U.S. home mortgage market, predatory lending, financial literacy education, behavioral decisionmaking, and a variety of consumer law topics. She is a member of the State Bars of Maryland and Massachusetts. Currently she teaches: Civil Procedure, Consumer Law, Contracts, and Problems and Reforms in the Home Mortgage Market.
Other papers written by Professor Willis I think you’ll find of interest…