Kelo With Caveats

My work on takings law reflects my strong disposition for free markets, and my concern that expansive interpretations of eminent domain powers lead to crony capitalism and other abuse. I believe that the Supreme Court’s facile equation of “public use” with “public benefit” in Kelo v. City of New London (2005) is particularly pernicious. So, I start out from the same premises as my George Mason colleague Todd Zywicki.

The Fifth Amendment to the U.S. Constitution explicitly conditioned the federal government’s condemnation power, and those restrictions subsequently were made binding on the States. “[N]or shall private property be taken for public use, without just compensation.” Even if a person is paid the going rate for his home or business, personal memories of home, the customization of business property, and the cost and dislocation of moving together make the condemnee almost certainly a substantial loser.

Government’s ability to condemn our homes or businesses in arbitrary fashion undermines both our financial security and our independence of the State. Those are necessary predicates for a democratic republic. The Supreme Court, however, has failed to recognize that the Fifth Amendment’s “public use” requirement serves those vital functions.

In Berman v. Parker (1954), involving sweeping urban renewal in Washington, D.C., the Court declared: “Once the object is within the authority of Congress, the right to realize it through the exercise of eminent domain is clear. For the power of eminent domain is merely the means to the end.” Thus, the awesome power of condemnation was reduced to one permissible government tool among many. Hawaii Housing Authority v. Midkiff (1984) was even more striking. There, the Court upheld the condemnation of the underlying ownership of land so that it could be transferred to the lessees. The Court declared that the public use clause was “coterminous with the scope of a sovereign’s police powers.” This means that, for whatever end government could regulate, it could take by eminent domain as well.

Justice O’Connor’s stirring dissent in Kelo famously declared: “The specter of condemnation hangs over all property. Nothing is to prevent the State from replacing any Motel 6 with a Ritz-Carlton, any home with a shopping mall, or any farm with a factory.” She referred to the statements in Berman and Midkiff as “errant language,” modestly omitting that she was the author of Midkiff. There, she approved of the result, whereas, in Kelo, she came to realize the full force of the uncabined government power she helped create.

By countenancing the use of eminent domain for urban “revitalization,” Kelo has abetted secondary rent seeking, by which builders lobby friendly local officials to condemn “blighted” land, with the understanding that the builders would be authorized to redevelop the land and gain substantial profits. The Supreme Court promised in Kelo to police against such abuses, but has refused to hear subsequent cases where abuse was palpable. For example, the highest court of New York State, in Kaur v New York State Urban Development Corp. (N.Y. 2010), upheld a grab of private lands by nearby Columbia University. In so doing, it reversed and chastised a lower appellate court that had determined from the facts that the condemnation was not in the public’s interest, but initiated to benefit Columbia itself. The appellate court’s sin was looking at the facts independently, rather than limiting its review to the redevelopment agency’s own record.

While we generally agree, I have a more nuanced view of the practical effects of eminent domain than Professor Zywicki. I will discuss this primarily in connection with currently proposed schemes by which local governments would condemn “underwater” mortgages, with their subsequent sale to sponsoring private companies. They, in turn, would provide the affected homeowners with refinancing, with the expectation of substantial profit.

As Zywicki writes, by basing compensation to condemnees exclusively on fair market value (plus modest statutory relocation costs, in some instances), eminent domain ignores owners’ idiosyncratic value. This is true, but sometimes the landowner accurately is described as a “holdout,” and desires to capture the lion’s share of the value of a public improvement. The owner of land in a narrow valley through which an interstate highway or railroad is slated to run is an example. Similarly, the revitalization project in Kelo could not be built in another part of New London, as Zywicki had suggested, since it was designed to by synergistic with a just-completed Pfizer pharmaceutical research center. Zywicki also notes that private developers often assemble large parcels through stealth. Practically, however, the greater transparency required of large government projects typically precludes that approach. Thus, while conservatives and libertarians argue that eminent domain should be constrained, they generally recognize that the power itself is salutary.

I believe that the bad associated with an enfeebled Public Use Clause substantially outweighs the good, and that condemnation should be limited to the traditional (1) use by the public, (2) use by the government, and (3) use by heavily regulated common carriers. Nevertheless, until and unless Kelo is repudiated, there is a plausible case to be made for government condemnation of underwater mortgages.

The housing bust that began in 2006 had several causes. A major reason, to be sure, was government insistence on expanding home ownership beyond those who actually could afford its responsibilities. However, there was similar housing price bubbles in many other nations, and in the U.S. commercial real estate market. Cheap money and irrational exuberance led investors to chase dubious deals.

The immediate trigger for the housing bust was the inability of borrowers to make mortgage payments. Some non-paying borrowers had received “teaser rate” loans. Those featured short-term artificially low interest rates that had been reset to market levels, resulting in greatly increased monthly payments. Other borrowers had “liar loans.” Lenders and brokers had accepted, or even cooked up, grossly inflated information about borrowers’ ability to pay, and no documentation of income or wealth was required. As a result of defaults on teaser rate and liar loans, vacated houses and foreclosures resulted in substantial blight and the lowering of housing prices throughout affected neighborhoods.

Declining prices, in turn, led to home valuations being less than outstanding mortgage balances (i.e., the houses became underwater). Depressed levels of business activity, resulting in part from the poor housing market, meant that underwater owners, by now often unemployed, were unable to sell and move to areas where there were jobs to be had. It also led to an inability to refinance, and to a spiral in which foreclosures led to lower housing prices, which led to more foreclosures.

In many cases, mortgagees motivated by enlightened self-interest would have worked out refinancing at lower rates, or permitted short sales or even partial loan forgiveness. These possibilities, however, largely were stymied by innovations in real estate finance. The originating banks or mortgage brokers did not hold on to real estate mortgages. Instead, they sold them to packagers, both quasi-public and private. These institutions, in turn, created large blocks of similar mortgages and issued complex securities, for which the mortgages served as collateral.

Trustees were appointed to hold these blocks of mortgages. They, in turn, arranged for very low cost servicing agents to collect and distribute mortgage payments received, and to make the (few) necessary foreclosures. Such arrangements were very cost-effective, so long as real estate markets were booming. When the bust came, however, they were shown to be woefully inadequate. Trustees who might have instructed the servicers to agree to accommodations with borrowers were concerned about unclear, but potentially large, legal liability to bondholders who might claim that the trustees had dissipated their collateral. Even if trustees were inclined to relax the mortgage terms, the small and poorly trained staffs of their servicing agents simply were not equipped to process the large volume of loan adjustment applications that would ensue.

Whether we like it or not, in areas ranging from building code compliance through aesthetics, courts have upheld regulations designed to protect the tax base of communities from substantial decline. Steep declines in housing prices, resulting from the practical inability of lenders to adjust existing mortgage loans, is a similar instance where use of the police power is plausible. Kelo, after all, equates “public use” with “public benefit.” Furthermore, courts have upheld the condemnation of all sorts of assets, including leases, contracts, patents, and even sports teams. All of this leads to the conclusion that the condemnation of underwater mortgages to buttress housing values and protect a city’s tax base is constitutionally valid under present law.

This is not to say, however, that condemnations of underwater mortgages are advisable. One problem is that the condemnations would be at fair market value instead of the higher face value of the outstanding debt. This would be analogous to a “cramdown” provision in bankruptcy law, which Congress specifically disallowed for residential housing in order to induce lenders to extend more and cheaper mortgage credit. Lenders already have vociferously objected to the possible condemnation of mortgages, and their response to it might well be to cut down on new credits that would hurt residential borrowers in the long run.

Also, condemnation lawyers earn their living largely by litigating for higher “just compensation” awards. The mortgage condemnation schemes proposed thus far would be financed through subsequent refinancing for affected homeowners. The firms proposing the condemnation anticipate that they would acquire the mortgages cheaply from the government. They reason that the just compensation paid for the condemned mortgages would be based on the market’s discount for the numerous delays that lender foreclosures would face in state courts, and the requirements that lenders repair existing damage and maintain the homes both before foreclosure and until eventual sale to qualified buyers.

But those concerns are not readily applicable where borrowers have been current in their payments, and want condemnation as a predicate to the refinancing of their mortgages that would allow them to enjoy lower interest rates and smaller principal balances while remaining in place. The resulting litigation over just compensation for the condemned mortgages probably would be messy and time-consuming.

In summary, I believe that Kelo should be repudiated, but in the meanwhile it is our law. As Kelo explicitly recognizes, States are free to impose stricter standards on eminent domain. Many have, through legislation or court rulings. But the condemnation of underwater mortgages has not been proposed in states protecting private property.

It is well understood that, in the future, lenders should require substantial down payments and demand that borrowers document their credit worthiness. In addition, though, lenders should arrange for terms in both trust and loan-servicing arrangements that contemplate reasonable modifications of mortgage terms that might be in everyone’s best interest. The failure of lenders to do so in the past may well have prevented private ordering solutions that would result in reasonable accommodations that benefit both borrowers and lenders.

Having omitted contract provisions that contemplate bad times as well as good, mortgage originators and the buyers of mortgage-backed securities in part abrogated their responsibility to allow for practical private solutions to resolve what became pressing societal problems. It is this omission that opened the door to the possibility of government condemnation of underwater mortgages.