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The failure to address crippling household-debt burdens is leading local governments to embrace the radical idea of using eminent domain to seize and write down mortgages.
Over the past month, two cities in California — Stockton and San Bernardino — have made moves to file for bankruptcy. They have a combined population of about 500,000, and Stockton is the largest city in U.S. history to file for bankruptcy.
The bankruptcies are largely a result of the unprecedented explosion in mortgage credit during the early 2000s. In research with Atif Mian of Princeton University, we measured exposure to the mortgage-credit boom using the fraction of households in an area with low credit scores as of 2000.
During the boom, these low-credit-quality areas had an unprecedented increase in mortgage-credit originations driven by private-label securitization, which helped push up house prices to unsustainable levels. During the bust, these areas experienced the worst outcomes, including very high rates of default and foreclosure.
San Bernardino and Stockton fit this pattern. As of 2000, both cities had among the highest proportions of low credit- quality borrowers in California. From 2002 to 2005, mortgage originations grew a stunning 155 percent as house prices climbed 80 percent. The household debt-to-income ratio rose from 2.0 to 3.5.
The housing-price boom in these areas proved to be ephemeral: House prices have fallen 57 percent since 2006 and foreclosures have skyrocketed. The default rate on household debt in 2009 in these cities was 33 percent; that is, $1 of every $3 of household debt was in delinquency.
And the damage from housing quickly spread to the rest of the local economy. In these two cities, auto sales have plummeted 50 percent from their 2006 levels (compared with an average 21 percent in other U.S. cities). Employment has declined almost 7 percent (compared with an average 3.7 percent decline in other U.S. cities), and the unemployment rate is 14 percent, about 6 percentage points higher than the national average. With housing values and economic activity collapsing, the cities couldn’t keep up with their debt payments.
Of course, other factors, such as poor city management and big spending, amplified city budget difficulties. But there is little doubt that the mortgage-credit boom played the starring role.
The San Bernardino and Stockton episodes are representative of a national crisis: Crippling household-debt burdens and foreclosures have been dragging down the economy for the past five years. Renegotiation of underwater mortgages by the private sector has been almost nonexistent. Despite strong evidence that frictions related to securitized mortgages are preventing the efficient restructuring of household-debt burdens, policy makers have largely sat on the sidelines.
With local governments feeling directly threatened, some cities have put forth a bold solution: Governments should use eminent-domain powers to buy mortgages, impose losses on bondholders, and write down principal amounts owed by the borrower. The argument is pretty simple: Debt burdens and foreclosures are crushing our cities; private lenders are showing no willingness to renegotiate; and there are no meaningful attempts at the federal level to help. San Bernardino and Stockton are Exhibits A and B.
Using eminent domain to impose losses on bondholders is unquestionably a radical idea. Creditors view such disregard for private contracts as outrageous. If the proposals are successful, it might help debt-ridden cities in the short run. Yet the resulting legal uncertainty might also wreak havoc on credit markets in the future.
At the same time, it is important to recognize how we got to this point. Debt contracts require debtors to bear almost the entire shock when aggregate asset prices decline. The unemployment and household-spending data coming out of places like San Bernardino and Stockton tell us that borrowers are indeed paying a huge price.
There comes a point, however, when it becomes impossible to impose further losses on debtors. And when that happens, creditors are expected to take losses on their positions. This is exactly why restructuring debt contracts is a valuable and important part of the financial system. In corporations and commercial real estate, such restructuring happens every day.
But this isn’t happening in mortgage markets. Even five years after the housing crisis began, the latest estimates suggest that more than 20 percent of properties with a mortgage are underwater, and the amount of underwater mortgage debt is close to $1 trillion. The vast majority of these homeowners haven’t been able to refinance with lower rates. So the lack of renegotiation isn’t just about principal writedowns; lenders haven’t even been willing to allow underwater homeowners to refinance with lower rates.
Bondholders and other creditors are understandably furious at the violation of private contracts implied by the eminent- domain proposals. They shouldn’t be surprised, though. Everyone has a breaking point. Proposals to write down debt will become even more radical unless the private sector shows a greater willingness to renegotiate mortgages.
(Source: Amir Sufi, Bloomberg)
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