Eminent Domain is Coming to Richmond, CA

July 30, 2013July 30, 2013Danny Vinik 4 Comments

After quite a bit of searching, Mortgage Resolution Partners (MRP) has finally found a town willing to take a chance on its plan to use eminent domain to help underwater homeowners. The details for this specific plan aren’t quite clear yet, but this plan still has a major problem. Let’s first look at how this will work.

Richmond is giving investors a choice: either willingly sell or we’ll use eminent domain to force you to sell. According to the New York Times, the city is offering to pay what it deems to be fair market value:

The city is offering to buy the loans at what it considers the fair market value. In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default.

MRP’s plan has been to put up the capital for these purchases so that no taxpayer money is involved. After it has purchased the loan – either by agreement or by force – the city will write down the value of the loan so that the homeowner is no longer underwater and can refinance at lower rates:

Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program. The $30,000 difference goes to the city, the investors who put up the money to buy the loan, closing costs and M.R.P. The homeowner would go from owing twice what the home is worth to having $10,000 in equity.

Done correctly, using eminent domain to purchase underwater homes is a promising idea. Unfortunately, MRP’s plan has always been aimed at helping investors make a nice profit, not helping out homeowners. This plan has the same major flaw: it doesn’t just write down loans for homeowners delinquent on their loans, but also for borrowers current on them.

The intellectual godfather of the plan, Cornell professor Robert Hockett, noted in his paper promoting the plan that MRP would only contribute capital to use eminent domain for mortgages that are current. The problem with this is that these are the homeowners who don’t need help. Yes, they are severely underwater and would be helped by a principal write down, but they aren’t defaulting on their loans. They are still able to make their payments.

Of course, for that reason, those borrowers are also the most valuable for investors. Homeowners current on mortgage payments on a $400,000 loan that is for a house worth only $200,000 is still profitable. The security is no longer worth face value since the losses in the case of default are now higher due to the lower home value. But that means the loan is worth somewhere between $200,000 and $400,000, depending on the risk of default. Since the home is worth $200,000 now, the loan is worth more than 100% fair value of the home.

MRP’s original plan was to only use eminent domain for homeowners current on their mortgages and would not pay anything more than 85% the fair market value of the home. As just shown, these loans are worth more than 100% the value of the home. No investor would ever be willing to sell at this price, even if it could solve the collective action problem that permeates the housing market (more on this later today).

However, this is the only way MRP makes money. If it were to purchase the loan for $250,000 (as it may be worth) and then refinance it at $200,000, it would lose money on the transaction. The only reason that the company earns a profit is because it’s using eminent domain to pay significantly less than the fair value of the loan.

Banks are (rightfully) furious at Richmond’s plan and will undoubtedly take this to court, arguing that the proposal is unconstitutional in a number of ways. Not least of all is the fact that eminent domain requires the city to pay fair market value for property. In purchasing the mortgages of homeowners who are current on their loans, Richmond is certainly not adhering to that rule. What really sucks for the city is that banks will likely freeze credit in the area as both a punishment and a deterrent to warn other cities not to follow in Richmond’s footsteps. Maybe more details will emerge that make this plan look like a better deal, but right now it’s looking like MRP finally duped a municipality into implementing its plan and Richmond is going to face severe consequences for doing so.

Ignoring the Social Cost of Carbon is Anti-Capitalistic

July 24, 2013Danny Vinik 1 Comment

The House is currently taking up a bill called the Energy Consumers Relief Act, which looks to put stricter rules on the Environmental Protection Agency (EPA). The bill requires the EPA to report to Congress on any rule that has costs greater than a $1 billion. It also allows the Department of Energy to veto any rule that it believes will cause “significant adverse effects to the economy.” Of course, the vague wording gives the DOE the ability to vacate nearly any rule it wants.

But I want to focus on two similar amendments to it. The first comes from Rep. Tim Murphy (R-PA) and it would prevent the EPA from considering the social cost of carbon (SCC) when it creates rules that have costs greater than $1 billion. The second amendment, from Reps. Duncan Hunter (R-CA) and John Culberson (R-TX), would only allow the agency to take into account the SCC if it put out a separate rule finalizing what the cost would be.

Preventing the EPA to consider the SCC is absurd. Pollution is the quintessential example of a negative externality in every economics class. Basically, companies emit huge amounts of carbon and other chemicals into the air, harming the environment and hurting society, but don’t have to pay for those costs. Since no one “owns the air,” companies can offload pollutants into it without hurting their bottom line. That’s where the EPA comes in. They set regulations to limit this behavior and force companies to pay for the pollutants they emit through regulatory compliance. The SCC is a major way of doing so. It estimates the social costs to society of releasing a ton of carbon dioxide into the air. In May, the Office of Management and Budget (OMB) increased the SCC from $21/ton to $35. That’s a big change.

The SCC increases the estimated benefits of regulation.

The way this works is that when the EPA creates a rule that will, for example, reduce carbon emissions by 100,000 tons, the social benefit of that regulation would be $3.5 million (100,000 tons*$35/ton). That would then be compared to the costs of the regulation. When the SCC is higher, the total benefits and net benefits will be higher as well. Companies want the SCC to be low – the lower it is, the less chance the EPA’s proposed rules will produce net benefits and the lower the chance the industry will have to comply with them. But economists love the SCC. It internalizes the negative externality of carbon pollution, creating more efficient, fair markets.

But Reps. Murphy, Hunter and Culberson aren’t buying it. The SCC is not an easy number to determine and the EPA and other agencies have tried to estimate it for a while. That means figuring out a final number, such as Reps. Hunter and Culberson want the agency to do, is challenging and will take a while. In the meantime, we shouldn’t just ignore the SCC because we don’t have a final answer. We should use the best numbers we have while continuing to research climate change and develop a more perfect metric. Rep. Murphy, on the other hand, doesn’t even care if the EPA comes up with a final number. He wants to ban the agency from using it altogether (for rules with costs greater than $1 billion).

The OMB’s decision to increase the SCC infuriated conservatives, but the correct response is not to prevent the EPA from using it. If it wants to develop a more accurate number, then increase the agency’s funding so that it can do more research on the social costs of carbon. But these amendments attempt to fix the problem by ignoring the SCC altogether. They do not promote free markets. In fact, they do the opposite. By preventing the EPA from internalizing the negative externality, they allow companies to pollute the environment without facing the costs.

For a party so committed to laissez-faire economics, that’s incredibly anti-capitalistic.

What If Wal-Mart Is Bluffing

July 23, 2013Danny Vinik Leave a comment

My post yesterday afternoon focused on why D.C. Mayor Vincent Gray should veto the living wage bill that the D.C. council passed a few weeks ago. As part of that analysis, I assumed that Wal-Mart will follow through on its threats to scrap plans to build six stores in the region if Gray signs the bill into law. I still believe that assumption is rock solid. As I noted in that article, if Mayor Gray signs the bill and Wal-Mart builds the stores anyways, it will set the precedent for every other city in America to enact similar laws. Wal-Mart could soon be paying a higher minimum wage than all of its competitors. So, I’m fairly confident that my assumption is correct.

But what if it’s not? What if Wal-Mart is bluffing? Should Mayor Gray veto the bill still?

The answer is still yes.

Under this assumption, Wal-Mart builds its stores no matter what, except in one scenario, it is paying significantly higher wages to its employees. In the current economy with unemployment high, the new stores would add 1,800 much-needed jobs to the District. Since we’re still not at full employment, the new jobs won’t impact wages for other firms in the area. That means Wal-Mart would be paying its workers at least $12.50 an hour while competing firms can pay them just $8.25/hour. The companies would be competing in the same market but forced to face different prices for labor. This gives smaller stores a big advantage over the giant retailer. Less efficient shops can compete with Wal-Mart thanks purely to favorable city policies.

D.C. Mayor Vincent Gray.

As we slowly get back to full employment, the living wage bill would start to affect other firms’ wages. At full employment, workers have more bargaining power and would want to work for Wal-Mart with its higher pay. This would force competing firms to increase their own wages to stay competitive in the labor market. When there isn’t excess supply of labor (as there is now), workers have more bargaining power. And when one firm is forced to offer wages at a 50% premium, workers have a lot more bargaining power.

This is fundamentally against free markets.

Wal-Mart would undoubtedly pass on some of the increased labor costs to consumers in the form of higher prices in the D.C. area. The same would be true at competing stores when they eventually face higher labor costs themselves. The 1,800 Wal-Mart employees would all earn more at the expense of consumers. And the market would still be distorted: Wal-Mart would still be paying higher labor costs and less efficient firms will be able to compete with it.

If the city believes that Wal-Mart’s entrance into the region will cause negative side effects (externalities) to occur, it can levy a tax against the firm and distribute the revenue to compensate those harmed. But distorting the labor market is not a smart way to correct the externality. The living wage bill does not compensate those who are harmed by Wal-Mart’s arrival, but instead helps the new employees of the company.

I also noted in yesterday’s article that D.C. council member Vincent Orange argued that Wal-Mart’s low wages forced the city to pay more in social services. But the same is true of any other minimum wage job in the area. If minimum wage jobs at Wal-Mart increase the amount D.C. pays in SNAP benefits (for instance), then every other minimum wage job does so as well. If the council member is looking to help the city’s finances by enabling people to rely less on the government, it should raise the minimum wage for everyone. Doing so for Wal-Mart hurts the company, but doesn’t address the underlying problem.

So, no matter whether Mayor Gray believes Wal-Mart is bluffing or not, he should veto the bill.

It simply doesn’t make sense to sign it.