![The government seized Susette Kelo's house for "economic development." Will the next bailout involve government seizure of private property? [Credit: money.cnn.com]](https://i0.wp.com/www.dougsbriefcase.com/blog/wp-content/uploads/2013/06/Susette-Kelo-house.jpg)
The government seized the land on which Susette Kelo’s house once stood. Will the next bailout involve government seizure of private investments for “public use?” [Credit: money.cnn.com]
The article’s title says it all — “Paying Paul and Robbing No One.” The author, Robert Hockett, a Cornell University professor, believes he has found the El Dorado of economics: the free lunch. Under his plan, millions of underwater homeowners (people who owe more on their mortgages than their homes are worth) would have their mortgage debts slashed and their monthly payments eased. By reducing the number of foreclosures, Hockett tells us, the mortgage writedowns would benefit not only the bailed-out homeowners themselves, but also their neighbors (fewer vacant houses), their local governments (since the bailed-out residents will be paying their property taxes) and the national economy (since they will be spending the money they save on their mortgage payments on something else).
That Hockett is calling for another housing bailout probably comes as a bit of surprise to most readers. Recent headlines suggest that the housing market is back: average prices are up, along with housing starts, sales of new and existing homes and construction jobs. Why fix what ain’t broke?
Hockett helpfully digs beneath the cheery headlines and finds less cheery news. Relying on data from CoreLogic, Hockett recites a litany of unpleasant numbers. Housing prices, though headed in the right direction, are still 30 percent below their peak value, he tells us. Worse still, 11 million mortgages — nearly one in four with loans outstanding — are underwater. Of these, he estimates that 3–4 million are in default, foreclosure, or already foreclosed and awaiting liquidation. Another 2 million homeowners are in distress, having missed two to four payments.
One solution would be for the banks that hold these mortgages to voluntarily take losses by writing down the debt. If a person owes, say, $400,000 on a house that’s only worth $300,000, the bank can just tear up the mortgage and issue a new one for $300,000. The bank, of course, would eat the loss, but the homeowner is better off and the bank is less likely to be forced to initiate foreclosure proceedings.
But things just aren’t that simple, as Hockett explains. While banks originated most of these distressed mortgages, they no longer own them. Banks typically sold the mortgages to entities, including private label securitization trusts, that bundled the mortgages together into securities and sold them to investors around the world. Since no single person or bank owns that hypothetical $400,000 underwater mortgage, no single entity has the authority to write it down to $300,000.
Most contracts that govern these mortgage-backed securities, Hockett notes, require a supermajority of investors to agree to write down the debt and take a loss. Good luck with that. Owners of these securities include individuals, pension funds, foundations, hedge funds, and foreign governments, to name a few. Even if they all thought it was a good idea to take a 25 percent loss on their investments, the practical problems of putting that to a vote are insuperable. And without such a vote, the trustees and loan servicers could not legally agree to the writedown. As Hockett puts it, there is no “collective agent” empowered to bail out distressed homeowners.
And that is where Hockett wants the government to step in. If the investors won’t – or, as a practical matter, can’t – sell their mortgage-backed securities at a steep loss and allow the underlying mortgages to be restructured, the government should take the securities away from them. The government could then write down the values of the mortgages and resell them to investors, including the same investors who were forced to accept the government’s take-it-or-leave-it price.
“Solving a collective action problem requires a collective agent,” he tells us. “As it happens, governments are also collective agents. They are likewise the sole entities authorized to sidestep the contract rigidities of the pooling and servicing agreements that stand in the way of broad writedowns for [mortgages]. But which government should take up this mantle – federal, state or local?”
Hockett’s answer: all of the above.
“Using their traditional eminent domain powers … states or their sub-units can compulsorily purchase underwater loans from private-label securitization trusts at fair value, dealing directly with trustees and sidestepping all contract rigidities. They can then write down the loans … If need be, eminent domain authority can also be used to take second-lien loans at fair value.”
So local governments, relying on the doctrine of eminent domain, should simply “sidestep all contract rigidities” and “compulsorily purchase” mortgage-backed securities that include underwater loans. Government should make investors an offer they can’t refuse: sell us your mortgage-backed bond at a “fair price” – not what you paid for it and not what you think it might be worth if you held onto it for another few years – and sell it to us now.
And where will the states and their sub-units come up with the cash to pay the investors what they and a judge deem a fair price? From the federal government, of course, although the original investors will be allowed to buy back the securities, assuming they trust the government not to screw them again. Over the longer haul, the government will turn a profit on this transaction, so long as the homeowners stay current on their new, lower payments and the value of their properties doesn’t dip again. And though Hockett swears that everyone wins under his scheme, investors that are forced to sell securities they don’t want to sell at a time and price of the government’s choosing may feel differently. The investors are the Peter that Hockett robs to pay Paul. So much for the free lunch.
But I want to look past that, along with the innumerable practical problems associated with the government seizing private investments, tearing up mortgages, writing new ones and selling them to investors, not to mention the problem of where the government will find the money to pull off transactions involving as many as 11 million homeowners.
Even if all of these practical problems could be worked out, the whole scheme depends on government buying something from people who don’t want to sell it. Hockett relies on the power of eminent domain, mentioned in the Constitution’s Fifth Amendment, which provides, “nor shall private property be taken for public use, without just compensation.”
Known as the “Takings Clause,” this provision stands against the practice that enabled kings to enlarge their estates by seizing people’s property. Under the Fifth Amendment, the government is empowered to take property for “public use,” but only if it provides the owner “just compensation.” The Founders meant this as a limitation on government, preventing it from following the royal practice of helping themselves to other people’s property. For one, it requires the government to provide the owners “just compensation.” For another, they can only acquire a property for “public use”; they can’t take property from one private person to benefit another.
At least the Constitution says they can’t. The Court has diluted the “public use” stricture in recent years, as a publication of the Michigan Bar has noted:
“While traditionally used to build roads, waterways, defense installations, government and public buildings, as well as the interstate highway system, it has in recent years become a favored method for urban development, creating shopping malls, and building big-box retail stores.”
The mutation from “public use” to “public purpose” was most famously on display a few years back in New London, Connecticut. City fathers were dangling tax breaks and other goodies to induce pharmaceutical giant Pfizer to build a new plant in their fair city. With the proposed new Pfizer plant as its crown jewel, the city’s urban development plan broadened to include plans for a sprawling residential and commercial center, complete with restaurants, retail stores, a hotel and a “small urban village.”
An economic development corporation chartered to oversee the project soon started to buy up the property from private owners and to use eminent domain to seize it from owners who objected. Susette Kelo was one of those objectors. A middle class woman trained as a nurse, she had recently bought her house and was unwilling to part with it. Kelo and her neighbors sued the city.
Their case landed at the US Supreme Court in 2005. Kelo and her fellow litigants argued that taking their property and selling it to corporate interests did not satisfy the Fifth Amendment’s “public use” requirement. By a 5–4 majority, she lost, with the court holding that this government-compelled transfer of property from one private owner to another served a “public purpose” that met the Constitution’s “public use” test. Writing for the four dissenting justices, Sandra Day O’Connor said:
“Today the Court abandons this long-held, basic limitation on government power. Under the banner of economic development, all private property is now vulnerable to being taken and transferred to another private owner, so long as it might be upgraded—i. e., given to an owner who will use it in a way that the legislature deems more beneficial to the public—in the process. To reason, as the Court does, that the incidental public benefits resulting from the subsequent ordinary use of private property render economic development takings ‘for public use’ is to wash out any distinction between private and public use of property—and thereby effectively to delete the words ‘for public use’ from the Takings Clause of the Fifth Amendment. Accordingly I respectfully dissent.”
The Kelo ruling, O’Connor says, shreds the Fifth Amendment’s “public use” limitation. The Court allowed the government to seize Susette Kelo’s property, not because it was needed for a road or a school, but because it thought that private developers could execute a project that would generate more tax revenue.
Hockett seeks to exploit Kelo’s expansive interpretation of the Takings Clause that allows government to compel the transfer of property to benefit one private actor over another. He wants the government to seize the assets of investors to benefit mortgage holders. He argues that his plan would serve a “public purpose” by helping communities still reeling from the real estate crash of 2008. If the City of New London fulfilled a “public purpose” by forcing Susette Kelo to sell her property for the benefit of private developers, wouldn’t a forced sale of mortgage-backed securities to write down the mortgages of distressed homeowners serve a similarly “public purpose?” If aggressive government intervention in the housing market so far has fallen short, why not try something really aggressive?
The sobering results of such aggressive government overreach were on display in April when Susette Kelo testified before the House Judiciary Committee. She called on lawmakers to restrain the use of eminent domain power that Hockett wants to expand.
“My name is Susette Kelo,” she told the committee, “and I used to live in New London, CT.”
She went on to describe how she had “finally found this perfect little Victorian cottage with beautiful views of the water” in 1997. “I painted it salmon pink,” she said, “because that is my favorite color.”
But the government also had its eyes on her dream house. Returning home on the day before Thanksgiving in 2000, she found a note from the New London sheriff taped to her door, “stating that the home had been condemned by the City of New London.”
Kelo lost her battle with the government. But in the end, ironically, she fared better than they. She was able to move her Victorian cottage out of the city and onto another property.
The outcome of the city’s urban renewal project was not so happy. In upholding the city government’s power to seize Kelo’s property, the majority of justices waxed rhapsodic about the plan’s presumed public benefits:
“The City has carefully formulated an economic development plan,” the Court wrote, “that it believes will provide appreciable benefits to the community, including—but by no means limited to—new jobs and increased tax revenue. As with other exercises in urban planning and development, the City is endeavoring to coordinate a variety of commercial, residential, and recreational uses of land, with the hope that they will form a whole greater than the sum of its parts.”
But the city’s actions did not produce the Court’s imagined results. Pfizer abandoned its plans to build a new campus there in 2009. Investors lost interest in the adjacent land and the private developer who was in charge of the works pulled out. The Seattle Times recently described the area where Susette Kelo’s house once stood:
“Weeds, glass, bricks, pieces of pipe and shingle splinters have replaced the knot of aging homes at the site of the nation’s most notorious eminent domain project. There are a few signs of life: Feral cats glare at visitors from a miniature jungle of Queen Anne’s lace, thistle and goldenrod. Gulls swoop between the lot’s towering trees and the adjacent sewage treatment plant.”
Policymakers should ponder that outcome should they ever be tempted to implement Professor Hockett’s far more ambitious government power grab for a “public purpose.”
By reducing the number of foreclosures, Hockett tells us, the mortgage writedowns would benefit not only the bailed-out homeowners themselves, but also their neighbors (fewer vacant houses), their local governments (since the bailed-out residents will be paying their property taxes) and the national economy (since they will be spending the money they save on their mortgage payments on something else).
They forget the one “person” who does get hurt — the homeowner who paid his mortgage payments on time. What about the taxpayer? I guess, because he has the audacity to actually have a job and bring home a salary, he is supposed to be delighted to pay EVERYONE’S mortgage!
Very good point. He’s wrong about the free lunch.
Please re-read the article. The key point has been missed. You say that ‘the whole scheme depends on government buying something from people who don’t want to sell it.’ That’s incorrect. The plan is aimed only at loans in trusts whose beneficiaries are unable to find one another to authorize writedowns that they do or would wish to authorize. This is a classic creditor collective action problem, on steroids. Collective action problems, for their part, are what even orthodox economists recognize under the category of ‘market failures.’ And market failures, for their part, bring deadweight losses — waste. The plan is designed solely to recover that lost value, then to distribute it back to all stakeholders — homeowners and bondholders alike. There might not be any such thing as a free lunch, but there are certainly lost lunches and recovered lunches. The whole point of the paper you here discuss, which I again urge you and all of your readers to read carefully (it’s pretty brief), is that there are many lost lunches — lost lunches that can be recovered. That, and that only, is what this plan is meant to do.
I disagree with your premise. These instruments are bought and sold all the time on the marketplace. People who own them are free to sell them anytime they want, if they’re willing to accept the market price. The point of the collective (government) action is not to relieve investors of something they don’t want, but to provide relief to homeowners who are in over their heads. By compelling the sale of all the instruments at a loss to their owners, the government helps distressed homeowners and, presumably, themselves. Investors who are willing to accept the market price don’t need collective action. A simple call to their broker will do. They can then put the proceeds to more productive use. If they instead choose to hold them, the government should not compel their sale.
1) ‘These instruments are bought and sold all the time on the marketplace.’ That’s simply incorrect, if by ‘these instruments’ you mean all of the loans targeted by the plan. There’s no occasion here to ‘agree’ or ‘disagree’ with the premise — just check the PSAs pursuant to which the loans we are targeting have been securitized. You will find that thousands of underwater loans simply cannot be voluntarily sold out of the trusts, either because the PSA terms expressly prohibit it, or because they do not permit it with sufficient clarity as to induce risk-averse trustees or servicers to sell or to modify. (Many servicers will tell you this themselves.) Of course thousands of *other* such loans *can* be modified or sold — their PSAs permit it and are clear about permitting it — and those are in consequence already modified or sold in large numbers, not out of trustee or bondholder benevolence, but to maximize NPVs.
2) It is odd to purport to inform me of ‘the point of the collective (government) action.’ The plan is mine, and that is NOT the point of my plan. The point of the plan, again, is to recoup a presently massive quantum of needlessly lost value, rooted in an altogether familiar form of market failure, and to distribute that recouped value Solomonically over all stakeholders — bondholers, homeowners, and their communities alike. Bondholders, I can assure you, ‘get’ that — I meet with them every week. They love the idea — and not only because they too are underwater homeowners. Quite a few servicers love the plan too, for reasons indicated above.
1) These instruments ARE bought and sold all the time. Not the mortgages themselves, but the
securities into which they have been bundled. The post was absolutely clear on that. The people who bought these instruments took on risk. If their investment has lost value, they can sell it. Many have. Those who have bought them have generally received a discount. No one is forced to hold an investment they no longer want. That some mortgages within a bundle are non-performing is a problem for the affected individuals, not a collective one.
2) The point of the collective action you advocate, since it requires use of the Fifth Amendment’s Takings Clause, must be to achieve some public purpose. The Fifth Amendment does not authorize the government to seize private property in pursuit of “Solomonic” ends. As I note in the post, I am not a fan of Kelo and I agree with O’Connor’s dissent that condemnations should be reserved only for “public use,” not to transfer property from one private actor to another, even if both parties would arguably benefit. As to the Solomonic nature of this transfer, I would again point you back to the results in Kelo. While city fathers and five Supreme Court justices saw the seizure of property as a way to “recoup a presently massive quantum of needlessly lost value,” it resulted in creation of a wasteland. If seizures for “public purpose” (as opposed to “public use”) are suspect, seizures based on speculation that they will benefit all concerned are doubly so.
1) The post was not actually clear about whether you meant the bonds or the loans, for it’s the fact that the LOANS cannot be sold out of the trusts in sufficient quantities that justifies my proposal, while BONDS’ trading actually STRENGTHENS the case for the proposal — a proposal that you disapprove. Insofar as the bonds actually trade, and trade at discounts, it is that much easier to show that the loans’ non-salability is occasioning lost value — value whose recoupment constitutes one of the proposal’s justifications. That the plan aides bondholders as well as homeowners, moreover, is one of its many attractions. (If you benefit all stakeholders, it would be very odd NOT to go forward with it.) Note also that the bonds’ actually trading renders the challenge of loan-valuation, and hence the fair value determination in court, that much easer. For the bonds’ discounts can be imputed to the underlying loans.
2) As you indicate, use of the eminent domain tool requires not only that fair value be paid, but also that a public purpose be furthered by the use. This is exceedingly easy to show in this case. Multiple municipalities in the ‘sun,’ ‘sand,’ and ‘rustbelt’ states are experiencing blight on an unprecedented scale as foreclosures bring mass homelessness, proliferation of abandoned properties, spillover effects on the values of neighboring properties, and plummeting municipal revenues owing to lost property tax base — ironically, just as abatement costs brought by abandoned properties skyrocket. In light of these facts — which are both documented and quantified at great length in my longer articles to which the briefer piece under consideration here cites — one should think of the present proposal as a sort of ‘inverse-Kelo.’ New London booted people from their homes on the basis of a highly speculative ‘economic renewal’ claim which of course did not pan out. The present proposal keeps people IN their homes and removes the principal source of very real, quantifiable blight. The fact that it also benefits creditors in so doing is just that much icing on the cake.
Thanks for engaging with the proposal.
1) Again, I don’t understand your confusion on this. The post is quite clear that bundling the loans into securities is what makes it difficult to write them down. But your point about the bonds, I think, gets to our fundamental disagreement. I don’t believe that government should be protecting the investments of bondholders. The decision to buy, sell or hold these instruments is up to the individuals who engage in the transactions. There is no collective obligation protect their investments, any more than there is a collective obligation to write down the mortgages of people who bought homes they can’t afford.
2) I appreciate the reverse-Kelo irony – the government confiscated a property that Kelo could afford; you want the government to discount mortgages on properties that homeowners can’t afford. That said, both require the government to employ eminent domain for something other than public use. I understand you believe that your idea can’t miss. So did the New London officials, who already had what they thought was a commitment from Pfizer to construct a big campus there. Sometimes these things just don’t pan out. If your homeowner with the smaller
mortgage loses her job, if the area suffers an economic setback, if the overall economy goes into the tank again, your idea produces the same result as in New London. But even if it were as sure a thing as you believe it to be, it relies on an unconstitutional use of government power.
It is, however, a very innovative and well-thought-through idea, and I appreciate your willingness to engage with me on its merits.
Thanks, Doug,
I’ve probably not been clear enough in my articulation of the idea, its mechanics, and its rationale.
WRT your point (1), the point of the plan is to enable bondholders to do what portfolio loan holders already do — modify loans to lower default risk and thereby render them more valuable — helping homeowners (by lowering their principal) and their communities as well in so doing. (‘Win-win-win.’) Currently they cannot do this unless they can all find one another to set aside the PSA provisions, which of course they typically cannot. Government’s role is simply to get past the PSA restrictions for them, with all current bondholders who wish to participate supplying the funds for the condemnation awards. Those funds can be supplemented, if need be, with nonprofit money and perhaps leftover TARP money or ‘Hardest Hit’ funds, but we don’t believe need will be. The government’s role is accordingly not to protect the bondholders’ investments, but to enable the bondholders to do mods that improvidently introduced contract rigidities now prevent their doing, mods that render all better off — bondholder, homeowner, and neighbors alike.
WRT your point (2), I am afraid I do remain confused. I don’t see how the plan threatens anything like what happened to Ms. Kelo’s neighborhood. Indeed a critical part of its purpose is to prevent that very thing and reverse the trajectory that many neighborhoods are now on in its direction. (Your evocative descriptions of New London now also describe underwater Atlanta, Cleveland, Detroit, Irvington NJ, Newark, North Las Vegas, San Bernardino, etc.) The plan is to purchase the loans, not the homes, and to write those loans down so as to KEEP folk in their homes. The analogy in Ms. Kelo’s case would have been for New London to assist investors in Ms. Kelo’s (here hypothetical) loan to write down that loan in a manner that results both in Ms. Kelo’s owing less and in the bondholder’s having more — by dint of the value recouped via lowering negative equity and attendant default risk. I don’t see how that could do anything other but improve things for Ms. Kelo and all of her neighbors who wish to stay in their homes and rise ‘above water.’
Thanks again,
Bob
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