Kelo and Call Options

Ownership of an asset entails rights - rather than obligations - to dispose of the asset as you see fit. Last week's Kelo decision shows that the Supreme Court justices need some education on this.

This distinction about rights versus obligations has increasingly led the field of finance to use the theory of call options to think constructively about assets. Thus, ownership of a real estate asset is like owning a call option with an expiration date that is effectively infinite (a super LEAP, if you will). The owner has the freedom to sell the real estate when they want to and to keep any profits.

The situation in Kelo vs. New London is that the homeowners have a call option that is in the money that they do not wish to exercise at this time. In most situations this is a right that is not infringed upon, which is why Kelo is so problematic.

What the Supreme Court has approved is that it is OK if the government has a potential owner who is willing to exercise the option to transfer ownership to them, have them pay the current owners the exercise price rather than the going price, pay taxes on the gain, and keep the difference.

Eminent domain is typically used only in real estate cases. But let's stretch a bit. I think there is ample reason to do this given that Justice Scalia did pin down New Haven as justifying their taking on the basis of increasing tax revenue. Tax revenue can be generated in many ways.

So, what is to prevent the government from going to the owner of a Google call LEAP with a strike price of $50? These are currently trading for a little less than $250 reflecting Google's current price of just more than $300. There is a lot of paper profit there that the government will get a piece of ... eventually. How much of a stretch is it to use Kelo to justify forcing the transfer of that option - at the strike price of $50 - to someone willing to exercise it now so that the paper profit can be turned into $250 of liquid cash to be split between the government and the new owner? This is farfetched, but if markets are efficient then the government is going to get its cut of that $250 eventually anyway, so why quibble about the timing? Further, it would be substantially cheaper to do this than a real estate deal - there just wouldn't be all those pesky details like environmental impact studies.

I think, viewed in this light, that it is hard to find any reasonable justification for Kelo.

P.S. My colleague Tim Lewis did make clear to me this morning that following Barron vs. Baltimore (1833) is an alternative basis for justifying the Kelo vs. New London decision.

Comments

[Brian Yamabe]

From a quick check on the Barron vs. Baltimore (1833) ruling (I'm not legal scholar), it makes sense that it could have been used. But, this would have kicked the legs out of many modern Supreme Court decisions, most notably Roe v. Wade. The extension of the Bill of Rights to restrain State governments as well as the Federal government is pretty much doctrine today.

[Dave Tufte]

You're right. My colleagues opinion was that he would have sided with the majority, but on the basis of it not being a Federal jurisdiction.

[Patrick R. Sullivan]

I'm not sure how the reasoning of Barron v Baltimore would apply. As Brian says, its 5th Amendment ruling has been overturned by the so called 'incorporation' of the 14th Amendment (O'Connor even mentioned it in her dissent).

Even though the congress that passed the 14th Amendment specifically refused to include the 'takings' clause in its language. Opting only for the 'due process' language.

Barron wasn't a taking anyhow. It was a tort claim. There was no reason for John Marshall to even entertain the 'taking' argument.

[Dave Tufte]

I will defer to better judgement from all commenters here, since MEGO when talking business law.

I do think though that the point about whether it was a taking or a tort depends on whether Barron's ownership extended into the water.

[PL]

What a thought provoking post. I'm not familiar with the details, but if the court ruled that the compensation paid to the property owners should be equal to the cost of redevelopment (the strike price of the real option held by the property holders) that could have some unintended consequences. First, developers would only be interested in taking over blighted areas where the cost of development is less than the value of the option, which I would guess is the exception, not the rule. Second, all developers would in some sense jointly hold a call option on all properties that has a strike price of twice the cost of redevelopment. If that option is in the money, then all developers will be willing to exercise it, and presumably politicians would have to decide which developer wins. At least that's my take on it.

I don't mean to nit-pick, but the particular GOOGLE LEAP that you mentioned doesn't seem to make a good example. If the LEAP was selling at $250 and had a strike price of $50 and the stock was above $300, you could buy the LEAP, exercise immediately and pay $50, and then turn around and sell the stock for a pure arbitrage profit, not accounting for commissions. Maybe the quotes were off.

[Dave Tufte]

1) The first paragraph is fine, it's just that usually economists (like me) assume that all opportunities to make money will be taken driving the prices to equality. If you want to assume that people won't do that because there are other frictions, then that is fine.

2) I rounded everything for the LEAP example - I didn't want the casual reader who doesn't understand options to get lost in the minutae.

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