Just Compensation Problems with the City of Richmond’s Plan to Use Eminent Domain to Condemn Mortgages

In my previous post on the the California city of of Richmond’s plan to use eminent domain to condemn underwater mortgages, I noted that the plan is likely to be permissible under the Supreme Court’s decision in Kelo v. City of New London, which says that a taking is for a constitutional “public use,” so long as it might advance some “public purpose” that isn’t “pretextual.” It may well also be permissible under California courts’ lax interpretation of of public use under their state constitution. But I didn’t consider another possible constitutional problem with the Richmond plan: undercompensation [HT: multiple VC readers who have directed my attention to this problem]. When the government condemns private property, the Fifth Amendment requires it to pay “just compensation,” which the Supreme Court has long interpreted as “fair market value.” As Matthew Yglesias sugggests, in many cases the formula used by Richmond would result in compensation below FMV (which is usually defined, roughly, as what the value of the asset in question would be if offered up for sale on the open market).

Here’s the compensation Richmond is offering, as described by the New York Times:

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.

If the home is worth $200,000 on the open market, as in the hypothetical example above, it is likely that the fair market value of the $400,000 mortgage should be at least that much, or close to it. Even if the owner defaults, the lender can recover that much through a foreclosure sale. And that analysis assumes a 100% likelihood of default. If we assume a more realistic probability of default of, say, 50%, then the FMV should be something close to $300,000 ($200,000 plus a 50% probability of recovering the remaining $200,000 on the mortgage). Even assuming an 80% risk of default in this case would lead to FMV compensation of about $240,000, which is 50% more than the city is offering.

These are only very rough calculations. For the sake of simplicity, I am ignoring such factors as expected mortgage interest payments (which would increase the market value of the mortgage) and the transaction costs of foreclosure (which would decrease it, especially in cases where the default risk is considered high). Nonetheless, it seems likely that, at least in many cases, Richmond’s approach to valuation would end up giving lenders much less than the FMV of their mortgages. In practice, lenders are likely to challenge the valuation on a case by case basis, which might lead to prolonged litigation, with the City losing some of these cases and possibly winning others.

To my knowledge, this would be the first time eminent domain is used to condemn mortgages on a large scale. So courts would have to set new precedents in determining how to value these assets for compensation purposes. This novelty makes the result more difficult to predict. Nonetheless, it is likely that courts would rule that the city’s formula leads to unconstitutional results in at least some cases.

The city could forestall this danger by offering compensation that really is equal to FMV or close to it. If it did that, it might not even need to resort to eminent domain, since it’s unlikely that very many lenders value these assets at levels higher than their market value. After all, few if any investors have any sentimental attachment to the securitized mortgages they hold. Obviously, however, increasing compensation would exacerbate many of the policy problems with the Richmond plan, especially the burden it imposes on poor and middle class taxpayers.

If Richmond proceeds with condemnations under its present compensation formula, the resulting legal battles over compensation will be of great interest to eminent domain scholars, myself included. It will also be an excellent source of income for California lawyers specializing in this field. As a property professor, perhaps I should support a plan so likely to enrich my fellow property lawyers. From a policy perspective, however, the compensation problem is yet another reason why Richmond authorities should reconsider whether they really want to go forward with this idea.