The Federal Reserve Bank of New York has published a paper by one of its former visiting scholars that flies in the face of the stated policy of at least one federal regulatory agency and is bound to stir up Wall Street interests once again. Paying Paul and Robbing no One: An Eminent Domain Solution for Underwater Mortgage Debt by Robert Hockett, Professor of Financial and Monetary Law at Cornell Law School, advocates a program of loan restructuring by state and local government which has been specifically denounced by the Federal Housing Finance Agency and drawn substantial fire from the private sector.

Hockett says that, in the view of many analysists, the best way to assist underwater homeowners is to reduce the principal on their home loans but the hurdles to principal write downs make this form of modification used less than would be optimal. One is the "last-mover" advantage that accrues to the creditors of later loans when principal is reduced on earlier ones. Then the Federal Housing Finance Agency (FHFA), conservator of the government sponsored enterprises Freddie Mac and Fannie Mae, has flatly refused to allow them to participate in write downs.

In the case of privately securitized mortgages, such write downs are almost impossible to achieve. The most decisive structural barrier is that so many of the pooling and servicing agreements require super-majority voting among the securities holders before the loans can be modified or sold out of trusts. And these investors, geographically dispersed and unknown to one another, cannot collectively bargain with borrowers or buyers on workouts or prices.

Moreover the agreements governing the loans prevent trustees and servicers from modifying or selling off loans in the requisite numbers. Finally the agreements typically stipulate servicer compensation that make it more profitable for them to oversee lengthy foreclosure proceedings than to pursue modifications.

There is the additional complication of second liens on many of the properties. First lien holders are rationally reluctant to modify their loans unless second lien holders do so as well while second lien holders often lack motivation to make concessions or have conflicts of interests because of relationships with the servicer and/or first lien holder.

The solution, Hockett says, is for state and municipal governments to use their eminent domain powers to buy and and restructure underwater loans. He and two others separately advocated federal eminent domain action in 2008, he says, but so far no such action has been taken and most of the emphasis in helping homeowners has been in the form of interest rate reduction and extended loan terms. Since 2007 little more than 1 percent of underwater loans have been written down. This weak response, he says, is surprising in light of the evidence that sizable write downs save value and that unmodified underwater loans will default at high rates.

Since neither the federal government nor the trustees of private label securities (PLS) seem moved to be the collective agents in solving the problems, then state and municipal governments appear to be in the best position to do so. They face the consequences of mass foreclosures and have the constitutional authority to address the structural issues.

Hockett suggests that sub-federal governments use their eminent domain powers to purchase underwater loans from PLS trusts at fair value, dealing directly with trustees and sidestepping all contract "rigidities." They can then write down the loan, reducing default risk and raising expected values in the process. If need be, the eminent domain authority can also be used to take the second-lien position at fair value or just the liens that secure them, leaving the notes behind as unsecured consumer debt.

Hockett has several suggestions for "Financing the Refinancing." One would be through federal monies lent in the manner of Treasury's Troubled Asset Relief (TARP) or Public-Private Investment Programs, or the Federal Reserves MBS stabilization programs, all of which turned profits. Alternatively they might raise money from private investors or a combination of federal and private funding which would be paid back from the proceeds of the refinanced and accordingly more valuable loans or from bonds issued against pools of the same. He suggests that if private money is used, the current bondholders should be given some prior claim to participation.

There are a number of issues to be confronted; (a) the selection and valuing of appropriate loans; (b) securing government and/or private investors; (c) commencing the eminent domain procedures; (d) modifying and possibly re-securitizing the loans; (e) working with homeowners; and (f) compensating investors at appropriate stages.

Hockett sees no legal issues with using eminent domain in this way; all types of property has been secured in the past in this way - tangible and intangible, contractual and realty-related alike. The question then is whether the public purpose justifies the taking and whether fair value is paid. The public purpose - "Preventing more foreclosures, blighted properties, revenue base losses, and city service cutbacks is recognized by courts as the most compelling of public purposes justifying use of the eminent domain authority."

There are many ways of setting value and it is not necessary to "rob Peter to pay Paul". Eminent domain proceedings need not represent zero sum games. The plan recoups value which can then be equitably distributed to render all stakeholders better off. First, lien holders who help finance the purchases from their PLS trusts receive loans that are higher in expected value in exchange for those with lower expected values.

First lien holders who do not so participate receive fair value for otherwise unmarketable assets. Homeowners gain modest equity and diminished default and foreclosure risk. Neighbors see their communities, property values, and municipal services stabilized, while municipalities see property tax revenue restores and abatement costs drop. Even second lien holders can benefit if paid a small fraction of the value of the asset.

The concerns that will probably be raised fall under two headings, Hockett says, those that debt write-downs always seem to raise - that it induces moral hazard and reduces credit availability - and concerns that the plan relies on state rather than federal authority.

The question of moral hazard, he says, is a personal issue that he cannot resolve but there seems to be little need to fear long-term contraction in liquidity or credit. Bubbles inflate only when credit is overabundant. The best way to get to safe middle groups is to clear out the overhang of negative equity then to ensure that pooling and servicing agreements mirror those in commercial MBS, anticipating the possible eventual need to salvage value. It is also important to remember, he says, that write-downs are done are mortgage debt all the time. It is called bankruptcy.

Concerns about using state rather than federal authority resolve around the problem of lack of uniformity in application. While some degree of national uniformity would be welcome, Hockett says, local conditions do vary and so fairness itself dictates some variation. Federal agencies, however, could be helpful in confining local variation within reasonable bounds as well as promoting efficient and amicable loan workout nationwide along lines like he proposes.

Hockett does not mention in his paper that something very similar to the eminent domain proceedings he suggests were recently announced by several cities and resulted in cries of outrage, threats, and proposed legislation.

In June 2012 the Board of Supervisors in San Bernardino County California announced they would use their power of eminent domain to take underwater mortgages from lenders and restructure them for borrowers at the fair market price.  Local governments in Chicago, Brockton, Massachusetts and other cities quickly followed suit There was also an almost immediate response from SIFMA, the trade organization representing the securities industry. It announced it would litigate any attempts to implement such programs and threatened that any community that did proceed would effectively find itself, shall we say, credit starved.

In August FHFA posted a notice in the Federal Register inviting comments on the issue. The notice said the agency had significant concerns about the use of eminent domains to revise existing financial contracts and the alternation of the value of GSE or bank securities holdings, and that it had determined that it might need to take action both as conservator of the GSEs and regulator for banks to avoid a risk to safe and sound operations and avoid taxpayer expense.  Any action it might take was unspecified

The following month Representative John Campbell (R-CA) introduced a bill titled The Defending American Taxpayers from Abusive Government Takings Act which would prohibit the four major government sponsored mortgage providers from buying loans in any community which used eminent domain in such a way. In January San Bernardino announced it was dropping the plan and the other communities have been very quiet.

It is interesting to speculate on the Fed's reasons for publishing Hockett's paper. Was it simply a scholarly attempt to air differing views on solutions to the financial crisis, or was the Fed flexing a few muscles in the direction of FHFA and Wall Street? Stay tuned.