Returning to Eminent Domain for Underwater Mortgages: Speak Quietly and Swing a Big Stick

Almost a year ago, The Economist calculated the cost to the big banks of Financial Crisis litigation at that time at nearly $100 billion. Since then, the U.S. Department of Justice has reached large settlements with two additional banks, Citigroup and Bank of America, which raised the price tag another $23 billion. That $100 billion figure highlighted by The Economist included a $32 billion agreement with some of the biggest banks to settle what has come to be known as the robo-sign scandal: where low-level bank officials fabricated court documents in tens of thousands, if not hundreds of thousands, of foreclosure cases. The Department of Justice is using these and other settlements to pressure more banks to resolve still outstanding mortgage claims.

What is striking about almost all of these settlements, including the $32 billion robo-sign agreement, is that they were resolved through negotiations only. In most cases, government lawyers obtained these large agreements without having to fire a single legal shot. Instead, they conducted investigations and threatened litigation, but only rarely did they bring a case to trial, or even file legal papers. Sometimes they would file legal documents after the fact, by submitting a complaint and a settlement agreement with the courts virtually on the same day so that they could have a judge monitor an agreement moving forward. But only rarely did these cases and investigation result in a trial and a ruling.

One exception is a case that was resolved earlier in the year against Bank of America, where a federal judge ordered the bank to pay over $1 billion for shoddy loan practices of its subsidiary, Countrywide, in just one loan program utilized during the mortgage frenzy of the last decade.

That one exception would appear to prove the rule: government lawyers and some private firms have obtained well over $100 billion in fines and penalties against financial institutions for their role in the events leading up to the Financial Crisis of 2008 mostly without engaging in protracted litigation and lengthy trials. In fact, in most instances, the mere threat of litigation, the risk of embarrassing and costly trials, and the possibility of exposure to larger fines and penalties are what brought banks to the negotiating table, and led to many of the settlements described here.

This pattern and history can offer guidance on the proper course local and state governments can take to deal with the lingering overhang from the Financial Crisis: nearly one in six mortgages in the United States is "underwater", where the homeowner's home is worth less than the outstanding principal on her mortgage.

Localities from across the country have considered using the power of eminent domain -- the right of government to take property and pay the owner "just compensation" -- to seize such underwater mortgages and rewrite them to align with home values. The City of Richmond, California, was the first to authorize the use of this power to take underwater mortgages, and other cities have expressed an interest in doing so.

The point of using eminent domain in this way is to pay banks the present value of these underwater mortgages. The mortgage holders will thus not receive the face value of the mortgages as compensation for the local government taking the property, but an amount that is heavily discounted. As my co-author, Nicholas Martin, and I explain in our recent paper, under the law of eminent domain, a government need only pay what a seller of the property would obtain on the open market if that property were sold at the time the government wants to seize it. A recent report from the U.S. Department of Housing & Urban Development shows that distressed mortgages are being sold for 60 percent of the unpaid principal of the mortgages. For banks, the unpaid principal balance of the mortgages is what appears on their books as an asset. If banks lose these mortgages through eminent domain, their books will look a lot different; they will reflect the discounted value of the mortgage, not its face value.

As one can imagine, banks hate this idea, and, as a result, the talks of cities using this power have subsided over the last year, as banks have claimed this use of a traditional governmental power goes too far, and it will hurt their bottom line. They also claim that the use of this power will only hurt the communities that wield it. Indeed, banks have said that if localities decide to implement eminent domain to seize underwater mortgages, bad things will happen to those communities. No one will want to lend there. No one will want to buy mortgages from there. The community will have a hard time accessing capital.

These claims are not new. Since the beginning of the Financial Crisis, banks have claimed that a lot of bad things will happen to them -- and the broader economy -- if regulators, Congress and other government actors do no more than ask them to make amends for their shoddy practices. Regulators have listened to them too often. In an essay for the New York Review of Books, Judge Rakoff, a federal judge from New York who presided over the Bank of America trial described above, said that government officials have internalized these fears, and taken a less aggressive stance against the banks than perhaps is warranted. Indeed, despite the substantial settlements described above, the results pale in comparison to the trillions in homeowner equity that the Government Accounting Office has found has been sapped as a result of the fallout from the Financial Crisis.

As we can see, though, no bank has failed as a result of the investigations and settlements government and private lawyers have been able to exact from the banks. Indeed, it has been mostly the threat of litigation, and not litigation itself, that has brought banks to the table to negotiate many of these large settlements.

Perhaps the mere threat that local and state governments might get serious about using eminent domain to seize underwater mortgages might be enough to get banks to do something they have been loathe to do from the beginning: write down principal and right-size mortgages to align them with current property values. Such actions would bring much-needed relief to hundreds of thousands of borrowers and make up somewhat for the trillions in homeowner losses from the shoddy bank practices of the last decade.