The use of eminent domain to seize underwater mortgages, a proposal being considered by San Bernardino County and two cities located in the county, would require expansion of the “public use” requirement of the U. S. Constitution. Although the “public use” requirement of the Fifth Amendment has been expanded by the Supreme Court’s interpretation of the idea as encompassing “public purpose”, the use of the power to condemn performing mortgages in order to accomplish the public purpose of curing malaise in the housing market, would likely fail the public purpose test. The stated purpose is both nebulous and would be difficult to prove with any certainty that the benefit would be achieved.
Reproduced with permission from Daily Report for Executives, 140 DER C-1 (July 23, 2012). Copyright 2012 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com
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Financial Industry Highly Critical of Plan To Seize Mortgages by Eminent Domain
By Stephen Joyce | July 20, 2012 08:54PM ET
July 23 (BNA – Banking Daily) — NEW YORK—A novel approach to ameliorate housing-market duress involving municipalities’ use of eminent domain authority to seize mortgages, not houses, is worrying the financial industry, which says the concept is flawed public policy, as well as unconstitutional.
San Francisco-based Mortgage Resolution Partners LLC is promoting a plan under which municipalities seize mortgages from existing securitized trusts using their eminent domain authority, refinance the loans with the assistance of government programs and a new infusion of private money, and repackage the newly originated mortgages into new securitization trusts. MRP and its affiliates would keep the difference—potentially billions of dollars—between the price of seized mortgages and the refinanced mortgages.
While proponents of the strategy claim it could help arrest foreclosures and their associated community blight, investors and their advocates say the seizures would violate state and federal law. Opponents also claim the program does nothing to address housing problems and instead enriches a select few by transferring private property from one group of private investors in a securitized trust to another.
“I think it’s bad policy and legally unconstitutional,” American Securitization Forum Executive Director Tom Deutsch told BNA July 19.
Law Professor Sees Win-Win in Brain Child
The overarching purpose of the program, as described in a June 2012 paper written by Cornell Law School Professor Robert C. Hockett, is to reverse the “remarkable toll in family and neighborhood suffering, ongoing and self-worsening value and revenue loss, and consequent blight that rolling foreclosures are now actively bringing in their wake.”
“Essentially it’s a way of enabling the bondholders [of the existing securitized trusts] and the homeowners to do a workout that ends up being good for both in a way that can’t be done now” because many securitization trusts prohibit modification of trust assets, even when such modifications would benefit the bondholders, Hockett told BNA July 20.
Three California jurisdictions—San Bernardino County, and the cities of Fontana and Ontario—joined to create a Joint Powers Authority, which is currently contemplating whether to implement a plan embracing the tenets of the envisioned Mortgage Resolution Partners program.
Hockett said that JPA may decide to issue a request for proposals to implement the strategy as early as August. A San Bernardino official did not immediately respond to a request for comment.
Other U.S. municipalities are also contemplating use of the strategy, said Hockett, who has written on the topic for years and has advised various entities on the strategy. “There are specific counties that are doing more than chattering, that are going to do this,” he said.
Structure of Transaction
Under the plan, municipalities seize by eminent domain so-called “underwater” residential mortgages, or those mortgages whose outstanding principal loan amount exceeds the value of the mortgaged home, from existing pools of mortgages held by securitization trusts.
In the San Bernardino instance, the municipality would use a so-called “quick take” eminent domain process, which would allow it to seize a mortgage quickly and provide “just compensation” to the securitization trust in an amount the municipality determined to be fair—an amount that could later be challenged in court. That just compensation would be funded by the new investors.
The Mortgage Resolution Partners concept contemplates paying out 70-80 percent of a property’s appraised value to the securitization pool as just compensation, specialists analyzing the deal told BNA.
The seized mortgages would then be modified, which would include decreasing the principal owed to the property’s current appraised value, and refinanced into a Federal Housing Administration loan and securitized by the Government National Mortgage Association, or Ginnie Mae, at up to 97.75 percent of the current appraised value—the current cap for FHA loan refinancings.
Opponents of the plan said they envision the municipalities would only seek to seize loans whose borrowers have made consistent, timely payments on those loans, but Hockett said municipalities would consider seizing any loan that could be improved through a refinancing.
Winners and Losers
The strategy would benefit borrowers because they no longer would be underwater on their mortgages. Plan facilitators such as Mortgage Resolution Partners and the new set of investors would benefit because they bought mortgages at perhaps 75 percent of a property’s original appraised value and would sell them to FHA at as much as 97.75 percent of appraised value, ASF’s Deutsch said.
The original investors in the securitized trust, however, would lose the difference between the current principal amount of the loan and the lower newly appraised value of the home, Deutsch said.
Hockett disputed that all investors would suffer losses, saying that investors in existing securitization pools would be the first invitees to participate in the resecuritized pools populated by the refinanced mortgages and thus could be in a position to realize an appreciation in the true value of their investment.
The current value of the bonds held by investors are really worth the principal loan amount of the mortgages minus the risk of default, which equals the current appraised value of the mortgaged properties—“the discounted expected cash flow that a particular mortgage loan offers given a particular default risk,” Hockett argued.
Eminent Domain Authority Challenged
A July 16 legal memorandum prepared for the Securities Industry and Financial Markets Association by O’Melveny & Myers LLP partner Walter Dellinger and others said the plan is subject to several legal challenges.
Existing investors, for example, could challenge the municipality’s use of eminent domain, arguing that seizing the mortgages fails to satisfy “public use” statutory requirements. The memorandum quoted from a U.S. Supreme Court case, Kelo v. City of New London, which held that “the sovereign may not take the property of A for the sole purpose of transferring it to another private B, even though A is paid just compensation,” the memorandum said.
The memorandum dismissed the argument the seizures could be utilized as an attempt to prevent future blight by arguing the only mortgages that would qualify for seizure would be those that are performing.
The memorandum also argued the plan is not an integrated urban planning program that would create widespread public benefit, but rather would create a benefit for a set of private investors possibly residing outside of the county.
“In our view, no matter how well intentioned this proposal may be, it is very unlikely to be a solution to the housing problem … because of the number of serious legal defects in the proposals,” Dellinger told reporters July 17.
U.S. Constitution Arguments Cited
The plan may also violate the U.S. Constitution’s commerce and contracts clauses, the memorandum said.
The plan could be interpreted as interfering with interstate commerce because the plan “would seize notes currently held outside California and integral to a complex nationwide market,” the memorandum said.
And while the U.S. Supreme Court has ruled states can alter contractual debts in certain circumstances, “the Court has never authorized states to abrogate debts outright and transfer them to another creditor,” the memorandum said.
The plan may also violate a San Bernardino County law that prevents the use of eminent domain to take property from one private party, without consent, for the purpose of conveying that property to another party, the O’Melveny & Myers memorandum said.
Proper Use of Eminent Domain?
A June 2012 Jones Day memorandum on the subject also asserted a “property seizure program” such as the one being contemplated by the three California municipalities violates the Fifth Amendment’s Takings Clause because it would neither be conducted for a legitimate “public use” nor provide “just compensation” for the owner of the mortgage.
“The proposed used of eminent domain in this case is a terrible idea. It does more harm than good for several reasons,” SIFMA Managing Director Timothy W. Cameron told reporters July 17.
Hockett disputed the notion the strategy would abuse eminent domain authority. “The prevention of blight or the arrest and reversal of urban blight is one of the most compelling of public purposes,” he said.
The O’Melveny & Myers memorandum noted the plan’s legal structure would potentially expose the county, participating municipalities, and municipal taxpayers to “enormous liability to existing note holders if courts recognize—as they likely will—the correct market value of performing loans.”
Hockett, again, disputed the conclusion that municipalities face litigation exposure, saying any litigation disputing “just compensation” amounts offered to trusts would be among the investors in the trust, not the government seizing the loans.
Program Seen Spooking Mortgage Lenders
If implemented, the strategy would result in restricting mortgage borrowing in jurisdictions implementing the eminent-domain strategy because lenders would be cautious, even reluctant, about underwriting loans on houses that may be subject to eminent-domain seizure in the future, opponents of the strategy said.
This wariness on the part of lenders could result in tightening lending standards, such as demands for larger down payments and higher potential-borrower creditworthiness scores, they said.
Further, an implemented seizure program could make potential investors in asset-backed securities whose underlying asset is a securitization of pooled mortgages hesitant to purchase the instruments, which could restrict consumer credit, at a time when the national economy is sluggish and the securitization industry is struggling to recover from its 2008 collapse, they said.
For More Information
The Hockett document is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2038029.
A Mortgage Resolution Partners presentation explaining its program is available at http://op.bna.com/der.nsf/r?Open=sfre-8wdqld and an FAQ presentation prepared for the firm is available at http://mortgageresolutionpartners.com/faqs.
SIFMA’s “eminent domain resource center” is available at http://www.sifma.org/issues/capital-markets/securitization/eminent-domain/overview/.
An ASF letter to the San Bernardino County Board of Supervisors containing its interpretation of plan details and explaining its opposition to the plan is available at http://www.americansecuritization.com/uploadedFiles/ASF_Eminent_Domain_Letter_7_13_12.pdf.
The O’Melveny & Myers LLP memorandum is available at http://tinyurl.com/c3p6kyu . The Jones Day memorandum is available at http://tinyurl.com/cccphkv.
