Saule T. Omarova

It is quite rare to come across a law review article that offers not only a theoretical diagnosis of a major socio-economic problem but also a plan for solving that problem in practice.  Putting forward a real, well-reasoned, and detailed policy proposal is always an act of scholarly courage, which inevitably exposes the author to all kinds of criticism.  This is especially true where the proposal targets a complex issue in which stakes are high, arguments are heavily ideology-driven, and powerful special interests dominate the agenda. Robert Hockett’s recent essay takes on precisely such a controversial issue: the nation’s continuing problem with underwater mortgages.  Since it was posted on SSRN several months ago, this essay has been making serious waves in policy-making circles (and earning its author no love from Wall Street).

Hockett starts with an incisive diagnosis of the root causes and structural dynamics of the mortgage crisis plaguing the nation since 2007. Five years after the bursting of the latest real estate bubble, mortgage debt overhang continues to be one of the primary factors impeding broad economic recovery in the U.S. and, consequently, globally. As Hockett argues, underwater mortgages – or loans on which the homeowner owes more than the current market value of the house – function as the principal drag on the U.S. housing market and the entire economy. Homeowners whose mortgages are underwater default at accelerating rates, leading to mass foreclosure, property degradation, and consequent asset devaluation. Moreover, such homeowners also don’t spend their money on purchases of goods, which depresses the consumer demand that is so vital to a robust economic recovery. According to Hockett, as of the beginning of this year, nearly a quarter of all mortgages in the U.S. were underwater, with an even higher concentration of underwater loans in certain especially hard-hit counties and cities. In effect, these are the loans that, while not technically in default, teeter on the edge of the abyss – and the more of them fall, the wider that abyss gets. Hockett argues that the only practical long-term solution to this problem is to write down the principal on underwater mortgages to post-bust market value levels.  That would effectively force the necessary adjustment in asset values and erase the crippling legacy of the pre-2007 real estate bubble.

Yet, so far, nothing has been done to implement this solution. Focusing primarily on private-label mortgage securitizations, Hockett identifies key structural obstacles to principal write-downs of underwater mortgage loans.  Thus, multiple investors in mortgage-backed securities suffer from a classic set of collective action problems and require collective agents – trustees or loan servicers – to act on their behalf. Unfortunately, the typical pooling and servicing agreements (PSAs), drafted during the irrationally exuberant bubble years, prohibit or effectively prevent modifications of mortgage loans, even where such modifications would bring down the loan-to-value ratio and potentially increase the market value of such loans.  The essay contains a thorough and lucid description of numerous built-in market dysfunctions and conflicts of interest among various market actors.  It is a logical conclusion, then, that the government is the only potential collective agent capable of overcoming such conflicts and contractual impediments.  Indeed, the core of Hockett’s argument is that the government has to use its constitutional powers of eminent domain to force write-downs of underwater mortgages.

Skeptical of the federal government’s political will to act to that end, however, Hockett proposes that state and local governments take the lead in this area.  He calls for states and municipalities – townships, cities, and counties – to exercise their eminent domain authority to take over underwater mortgage loans, compensate bondholders for the fair value of such loans, and then modify the loans by writing down the principal.  Not surprisingly, this is where the proposal makes many readers at least somewhat uneasy, if not outright hostile to the entire thing. Yet, they should stay with Professor Hockett as he patiently and eloquently takes them through the intricate details of his plan and explains how it complies with all constitutional limitations on exercise of a sovereign’s eminent domain authority. He dispels common confusions and misunderstandings of the relevant law and builds a convincing case for eminent domain as a “win-win” solution that would ultimately benefit everyone: homeowners, holders of mortgage-backed bonds, communities, and local and regional economies.

Of course, it is impossible to do justice to such a complex proposal in a few short paragraphs. It is also difficult to predict whether this creative and elegant plan will, in fact, become the blueprint for widespread local and state government action. Yet, the increasingly heated debate on the merits of Professor Hockett’s ideas and the apparent mobilization of various interests opposing (or, conversely, supporting) his plan suggest that it may well become such a blueprint. In any event, this essay is a must-read for anyone interested in financial markets and regulation.