Eminent Domain and Underwater Mortgages

Hey guys. I'm Danny and I'm interning at the Washington Monthly this summer. I'll be a senior at Duke University next year where I'm majoring in economics and public policy. I have my own blog at Across All Sports, which was mainly sports-focused but I've now expanded into political and policy blogging. Feel free to go check it out though I admit I don't update it as frequently as I would like.

And big thanks to Ryan for letting me add a few posts here while he's off crushing the rapids out West. Hopefully I can live up to the excellent posts he normally puts up. So let's jump right in:

I recently posted an article on the Monthly about the government acting on behalf of a private company using eminent domain to buy underwater mortgages at a slight discount. The company would then lower the principal on the mortgage to bring the loan back above water and allow the homeowner to refinance at a lower rate. The company would make a profit from buying at a discount, the homeowner would get to keep his home and the bank would get the defaulted mortgage of their sheets. Win-Win-Win. Except many banks have sold mortgage-backed securities to investors and those investors are not looking to get them off their balance sheet. They certainly aren’t looking to sell at a discount. I hypothesized that if the U.S. used eminent domain to take these MBS from investors, it would forever add greater risk to these investments and thus banks and investors would charge a higher interest rate to offset that risk.

You can go to the article and read it in more detail, but that’s not what I want to talk about here. I want to briefly discuss the idea that using eminent domain for mortgage-backed securities is different from using it for seizing a property for a new highway. There are slight differences, but in general, they are very similar.

First off, both a mortgage-backed security and property are investments. They can go up in value or down in value. Just because someone has a home on it, lives there and doesn’t think of their property as an investment doesn’t change that.

Secondly, eminent domain always results in the market bottoming out. Investors would be furious if eminent domain was used to seize their securities, because very soon afterwards, home prices would rise and those securities would have risen quite a bit in value. Why? Because if the government used a policy to bring millions of Americans above water, it would allow those homeowners to refinance at affordable rates and would significantly reduce foreclosures. Fewer foreclosures would spur house prices to rise even further.  Using eminent domain would cause a housing recovery.

But using eminent domain to seize property for a new highway works in a similar way. As soon as the government seizes the land, it immediately becomes more valuable because if a person were to own a piece of it, he’d be in a tremendous bargaining position. Because the government needs that land, the owner could hold out for a huge price. Thus, every piece of property immediately becomes more valuable as soon as the government seizes it precisely because the government needs it.

And this is all on purpose. This is why eminent domain exists. It would be incredibly difficult and expensive for the government to bargain with each investor individually to make sure it wasn’t grabbing his investment and wasn’t taking it right before the value skyrocketed. It’d be nearly impossible for the government to do that.

And while a highway is a much more practical use of eminent domain, bringing millions of homeowners above water is very beneficial to the public as well.

Now, there are certainly some differences. Using eminent domain to help underwater homeowners may reward those homeowners for taking out loans they can’t pay (or it could be taking out loans that they didn’t understand). Many people would argue this could create conditions for moral hazard.

With using eminent domain for a highway, none of that exists as everyone shares the benefits and no one is rewarded for screwing. There is no moral hazard.

But my main point is that the differences between using eminent domain for physical property and financial instruments are not as large as everyone makes them out to be. This doesn’t change the issue that I bring up in my Monthly piece, but it is worth pointing out.