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Eminent Domain and Underwater Mortgages: Solving the Municipal Fiscal Crisis

By Wallace Turbeville

The city of Richmond, California, has taken bold action to pull the community out of the depths of the residential real estate crisis. Its approach -- using eminent domain to forestall foreclosures -- promises relief for Richmond homeowners. But it also is a template for cities across the land suffering from their own fiscal crises and facing bankruptcy.

Like so many other cities, the plunge in real estate prices that triggered the Great Recession desperately wounded the community of Richmond. Many homes carry mortgage principal exceeding the market value of the property. The obvious solution would be to write down the mortgage balances to re-align with the new market. That’s what the mortgages are actually worth anyway and it has been shown many times that such a reasonable approach is best for both the homeowner and the lender.

The problem is that it is often hard to identify an actual lender to negotiate with, given the way that mortgages were chopped up and bundled during boom times. Using eminent domain to refinance cuts through this problem.

A workable solution

A number of cities have considered the use of eminent domain. In addition to helping their citizens who were injured by the crash, the cities understand that devastated home prices undermine the financial integrity of the governments. A 2012 study by the New York Fed details how distressed properties distort the tax revenues of cities and states. It turns out that indirect damage to sales and income tax revenues is even larger than the losses in property taxes, at least initially. Property tax losses are delayed as reassessment takes time and some cities increase tax rates to compensate lowered values. But it works the same way during a recovery. The effects will linger for years in some places.

A federal initiative would make sense, but the political will is not there. The effects of the real estate bubble burst vary dramatically from one location to another. It is at the state and local level that the political motivation is at its highest. It is perfectly sensible that cities and counties take the initiative if the federal government does not.

What about investors?

The Richmond approach has driven the securitization industry into a frenzy. Other local governments that have considered the use of eminent domain have pulled back for fear that the costs of threatened litigation would be too great to bear. It does not matter to Wall Street that the investors were ready to take on the risk of early fair market value payout as a result of fire, flood, individual default or more conventional eminent domain. According to the banks, systematic taking of mortgages at fair market value to save communities from the general real estate re-alignment was just not part of the deal.

Of course, it was part of the deal. Perhaps the bankers failed to anticipate the possibility and disclose it to the investors. If so, it would be just one of the things they failed to anticipate and disclose. It is not that eminent domain was not part of the deal; it was that the potential for a real estate price crash, and a response such as Richmond’s, was ignored. Richmond’s approach will not kill the securitization market if the crash itself did not.

Key to recovery

Healing the cities is essential to the recovery of the health of the economy and addressing the mortgage overhang is at its core. We have recently seen Detroit file for bankruptcy, and three cities in California did the same last year. There are those who want to make these bankruptcies, and those which will happen in the coming months, into an attack on public employees and their unions. They will focus the conversation on unfunded pension obligations and the tradeoff between the need to fund future retirement and health care costs and the need to satisfy the holders of municipal bonds. But that serves political interests, especially in a place like Michigan.

Just as redistricting and gerrymandering are battles between urban ex-urban political interests, the devastation of cities from the Great Recession provides an opportunity to realign political power. The eminent domain procedure addresses the real problem, fixing the local economy, and should be the way forward.

Wallace Turbeville is a senior fellow at the public policy organization Demos working on financial reform.