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This week Bruce Norris is joined Robert Hockett. Robert teaches financial and business law subjects at Cornell Law School, where his research and writing focuses on the legal and institutional prerequisites to a just and prosperous economic order. He is also a fellow at the Century Foundation, a commissioned offer for the New America Foundation and consultant to a number of financial institutions, regulators, and legislators. Prior to entering legal academia, he worked at the International Monetary Fund and served as a judicial clerk for the Honorable Deanell Reece Tacha, Chief Judge of the U.S. Court of Appeals for the 10th Circuit. He was educated at the University of Kansas Oxford University, where he studied as a Rhodes scholar. Robert also authored a memorandum entitled It Takes a Village Municipal Condemnation Proceedings and Public/Private Partnerships for Mortgage Loan Modification Value Preservation and Economic Recovery.
Bruce wondered how the idea for the aforementioned research paper came about, whether it was an idea he had or if somebody wanted him to write something for them. Robert said it was a bit of both. The basic idea goes back a good long way to the emergence of the crisis itself. Once the mortgage market peaked and then plunged back in 2006, a good many academics as wells as other policy types and interested professionals became interested in what might be done about what looked like it would turn into a significant national real estate crisis that would have fallout effects or knock-on effects that would ultimately culminate into a financial crisis.
When the financial crisis itself began to emerge and become conspicuous around the summer of 2008, some of the academics in particular became concerned with how they might best put a floor under still-plummeting real estate prices. How might we stabilize the real estate markets and thereby stabilize the broader financial system. A few, including Robert, began suggesting concentrating holdings of some of the mortgage loans, in particular the underwater mortgage loans while at the same time preserving value. Robert’s clients claim was that there was something like a bankruptcy under way. A lot of the toxic assets were being valued by the market at even less than their sustainable value was. Their real value was less than what their bubble values had been, but nevertheless the bust value was even lower than the current market value. The claim was that you essentially had the opportunity to assemble large blocks of these things to address the problem. Once the TARP money became available, Robert said he would suggest that it should be used to do that. If you fix the mortgage loan problem with TARP money, you will thereby fix or stabilize the destabilizing financial markets. Some people agreed with this, while others did not.
Robert also argued at the time regarding trying to amass those large holdings of mortgage loans. Any government instrumentality that found some people were unwilling to sell and who would exercise holdup power to extract a higher price from government authorities that would be buying them up should use eminent domain. Robert went from here to saying various Federal instrumentalities, whether FHA or the GSEs should use eminent domain if necessary. Around the same time, a couple of other academics began suggesting use of eminent domain as a first resort rather than a last resort. Robert argued that it should be used as a last resort. He did not think it would likely be necessary because he thought that given the way in which the market was undervaluing the assets at the time could probably be purchased at a decent price by Federal Instrumentalities anyway. In the event of holdouts for some people, Robert argued that eminent domain could be used. The other academics were suggesting that eminent domain should be used as a first resort. The three who were talking about this, including Robert, were talking in terms of Federal Instrumentalities using this authority. As things progressed and continued and it began to look less and less likely that the Federal Instrumentalities would do anything like this, some began talking about the possibility of using state instrumentalities or municipalities.
The state and municipal use of eminent domain as a fallback option got onto the table pretty late in 2008/2009. Those who had proposed the ideas kept talking about them in various articles and pieces that they wrote. Eventually, about a year ago an old classmate of Robert’s from his Oxford days who founded an entity known as Mortgage Resolution Partners began thinking about trying to actually pursue the municipal version of the eminent domain idea. To make things even more interesting, he retained the services of another friend of his to help put together a plan that would work financially. Both of his friends approached him earlier in the year to assist with thinking things through legally partly because they knew he had written in the area for a number of years as well as they knew him and were old friends of his. That is essentially how he got involved with MRP in particular.
The report was done almost entirely in 2012. It is essentially the product of lots of work that he had done in the months and even years preceding the MRP approach to San Bernardino and others. The one exception is that some of the specific legal analysis that you find in section 4 of that particular memorandum was done specifically in response to MRP’s questions because MRP said they were interested in California to begin with. Section 4 provides a legal analysis. Part of the analysis is Federal in character, and part of it is State law in character. The State Law Analysis is Californian, and the focus on California is a direct product of MRP having asked Robert to help them think through the legalities of launching an eminent domain program of the kind that he had talked about in years past in California.
Bruce wondered if there was any recent trends in the marketplace that would have Robert change anything in the report. He said there was none that he could think of. There have been some recent reports saying that maybe we have reached the bottom of the mortgage market and maybe there are not as many foreclosures down the pike. However, this seems to happen every few months, and we always end up in the same place. Nothing really significant seems to have changed since he wrote the report.
It was stated in a quote, “The gist of pre-eminent domain is that any sovereign authority, so long as it acts and in the name of the people holds dominion over property within its jurisdiction that is implicitly prior to that of any particular individual.” This means if you own a property that gets in the way of a great public service, the government has the ability to take it from you and pay you for it. It is kind of a residual authority that any government has to cause to occur what our English forbearers used to call a compulsory sale in the interest of the broader public. Bruce wondered what conditions must be present for that to occur. Robert said there are basically two conditions. The first is that there must be an actual public service. It cannot be simply to benefit one private party at the expense of another. This would be unjust and contradictory to the basic values that underpin our Constitutional order. There has to be an actual public service, and it has to be a real, bonified public service and not a merely pretextual one. The second condition is that fair value has to be actually paid. Fair value is taken quite seriously by the courts. For example, if the government announces that it is going to take a certain form of property and the prices on the property go down because the government has made this announcement. If the prices go down after the announcement, then the government announces that it is going to pay those lower prices that have been arrived at, this would not be fair value. This would be a transparent case of unfair value. For that reason, our Constitutional order and the eminent domain authority that we have under our Constitutional Authority has always been understood to exclude that kind of chicanery.
What this means in turn is if there are actual markets out there for equivalent kinds of property, those actual market prices are relevant in determining what fair value is. In the absence of such markets, one has plausible valuation methods, and there are all sorts of very orthodox, familiar, and widely accepted methods or methodologies of valuation that are the subject of lots of business school text books. There is the discounted cash flow method and other valuation methods, almost all of which are known in terms of being widely accepted. Obscure valuation methods widely accepted but are highly unorthodox would typically not pass through the courts or Constitutional luster.
Many of us would be aware that eminent domain would apply in areas such as San Bernardino or Riverside County where there is a lot of population, expansion of freeways, and where we have seen several houses close to the freeway disappear. However, not many of us were aware that it could apply to something like ownership of a loan. Bruce wondered what the precedent is for this. Robert said many non-lawyers tend to associate exercises of eminent domain with compulsory sales of real estate, whether it be houses or strips of land. The reason we can associate eminent domain with that kind of compulsory sale is because that kind of sale is usually conspicuous. For one thing, you see that house when you drive by it on the freeway, then later you notice it is gone. A lot of us develop territorial attachments to our real estate. Your home is your castle and something you develop a very close psychological association with your property in the same way that all sorts of animals develop territorial imperatives in the areas they hunt. We tend to be especially surprised by compulsory sales or takings of that kind. These two reasons, the conspicuousness on the one hand and the invocation of our territorial tendencies on the other hand are probably the two principle reasons that we are much more apt to notice exercises of eminent domain over that kind of property.
Nevertheless, any lawyer or lay person who knows about property law, eminent domain authority, or local government or land use law will be able to tell you that eminent domain authority applies to all forms of property. As new forms of property come into existence over the decades and over the centuries, new forms of property that are subject to eminent domain authority also come into existence. So for example, 100 years ago there was probably nothing that would be called intellectual property. Nowadays, intellectual property is among the most important kinds of property. Intellectual property can be subject to eminent domain authority. The broader category under which intellectual property fits is the category of intangible property. It has long been understood and appreciated that eminent domain extends to intangible property. It is extended to those forms of property for as long as they have existed. This is the first part of the answer. The second part of the answer regards precedent. There is all sorts of precedent. For example, eminent domain authority over the last few decades has been exercised in relation to railroad stops and other forms of debt. It also relates to sports franchises, notably the Oakland Raiders.
The eminent domain powers of one of the public services it provides is to prevent blight. In looking at this, Bruce looks at blight and thinks about Riverside’s or San Bernardino’s type of blight, then he looks at Detroit’s. There is all sorts of levels of blight, and Bruce wondered who would determine that the level of blight has reached serious proportion. Another interesting thing Robert’s report said was that it was not only for the reversal, but also the prevention of likely blight. Robert said with various municipalities, as long as they have Democratic local governments and are recognized by the courts as having a fairly wide range of legitimate discretion in determining what counts as blight, then there is a fair degree of discretion that all counties and all Democratically Legislative units of government are recognized by the courts as having. Secondly, there are limits and a range of discretion, but it is on the infinite range. The question then is what the limits are. The answer to this is court decisions that interpret Constitutional provisions that apply to the governments in question. If you are talking about a municipality, this means that the state Constitution is one that provides one limit. The Federal Constitution, as interpreted by the courts, provides another limit. Typically those two sets of limits coincide, but in theory they could diverge. When they diverge, it is the Federal Constitution that trumps.
The next question is what the Constitutional limits are. The outer limits of the authority have most recently been determined by the U.S. Supreme Court in the famous kilo decision in 2005. This was a decision in which Connecticut determined that there was a significant likelihood of some degree of revitalization that the city of New London would enjoy. If the city were to confiscate at fair value home that were lived in by predominately elderly and lower income citizens, then they could convey that property to create a pharmaceutical development of some kind. This was conveyed as controversial by some for a couple of reasons. For one thing, the public purpose, namely economic revitalization, was viewed by many as a very speculative claim by city of New London. You could not say with certainty that there was going to be a definite substantial boost in economic activity just by a dent of conveying these properties over to the private firm known as Kaiser. The second reason for the controversy was that in view there was a conveyance to this private firm, in other words a conveyance of private property from one party to another property was a means of attaining that putative end known as economic revitalization. Notwithstanding these, the speculative nature of the economic benefit to the community on the one hand and the fact that a means toward that end was a conveyance of property from one private party to another on the other hand, the Supreme Court rather infamously upheld that exercise of eminent domain authority by the city of New London Connecticut.
What is interesting about that is for one, it does suggest that the limits on exercises of the eminent domain authority as far as the Constitution is concerned, are fairly broad, broader than some people thought in 2005. The second interesting thing is Robert finds it very instructive to contrast the situation you are in in the Kilo case with what you find in San Bernardino. Their possible use of eminent domain right now is constituting a kind of inverse Kilo. They are contemplating use of this authority to keep people in their homes and not boot people from them. You also have a merely good, not quite speculative, but quite determinate case to be made here that blight will indeed be reversed and/or prevented. The reason for this is manifold, but among the reasons are if you have mass homelessness suddenly taking place owing to mass foreclosures in a particular county, that is going to create all sorts of local dysfunction in its own right, which will mean property values will take a huge hit. This means the city loses its revenue base, city services are retracted, and the city goes bankrupt. This means that even people who are current on their loans or don’t owe anything on their houses will lose value in their homes as well. Many will be tempted to leave, and this will add more property to the current glut and drive prices down even farther. You then have the classic vicious spiral downward.
All of this happened back in 2008 and in some ways began even sooner. However, it is not finished. A lot of the numbers laid out in the beginning bring this out. Half of the mortgage loans in San Bernardino right now are underwater but have not already defaulted. As we know, underwater mortgage loans are very likely to default. This means San Bernardino can look forward to even more delinquencies, defaults, foreclosures, property value hits, revenue base hits, service retractions, and a mass exodus. San Bernardino, which now has the second highest poverty rate next to Detroit might end up surpassing Detroit if things continue as they are currently going.
Tune in next week as Bruce and Robert discuss specifically some of the things going on in the current marketplace. There is a lot of demand in the marketplace and a slowdown in foreclosures. A lot of people were foreclosed on in ’08 and ’09 who are now re-emerging as buyers and creating a lot of demand for the product. In the next segment, they will discuss the Hawaii court case known as Metcalf and its intention and final result.
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About Bruce Norris
Bruce Norris is an active investor, hard money lender, and real estate educator with over 30 years experience. Bruce has been involved in over 2,000 real estate transactions as a buyer, seller, builder and money partner.
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