Eminent domain, MBS and the U.S. Constitution: A one-sided fight?

By Alison Frankel
July 11, 2012

If you’re already inclined to suspect governments of overreaching, boy will you hate the plan San Bernardino is contemplating.

About half of the homeowners in the newly bankrupt California city are underwater, which means they owe more on their mortgages than their homes are worth. In conjunction with a San Francisco outfit called Mortgage Resolution Partners, San Bernardino is considering a plan to exercise eminent domain and seize mortgage liens on some of those underwater homes. As my Reuters colleagues Matt Goldstein and Jennifer Ablan were the first to report, the eminent domain scheme works like this: With financing from an outside operation such as MRP, the city would condemn underwater mortgages and purchase them in the name of the public good for a court-determined fair market price. The financier would then make new mortgage loans to homeowners under modified terms before turning around and selling the modified loans to outside investors. As eminent domain proponents describe the plan, it’s a winner for everyone: Homeowners see their loan principal reduced and get to keep their houses, financiers turn a profit on the resold mortgages and the city avoids the blight of foreclosed homes, which drive down property values and destroy neighborhoods.

But there are also losers in the eminent domain model: investors in mortgage-backed securities. San Bernardino is talking about exercising eminent domain only over mortgage loans that have been bundled into private securitizations. Those mortgages are owned by MBS trusts, which, under eminent domain, would be forced to accept fair market value for underlying loans they don’t want to sell. To add insult to injury, the San Bernardino plan proposes that only performing loans be part of the initial wave of eminent domain seizures. That’s to reward homeowners who have managed to live up to their mortgage obligations. But from the perspective of MBS investors, seizing loans that are still being paid on time means they’re being stripped of an ongoing revenue stream.

You can see why MBS investors and other industry groups are up in arms about the eminent domain solution to the foreclosure crisis. To them, it’s tantamount to government-sanctioned theft. At the end of June, a coalition of 18 powerful players, including the American Bankers Association, the Securities Industry and Financial Markets Association and the Association of Mortgage Investors, sent a joint letter of protest to the San Bernardino Board of Supervisors. “We believe that the contemplated use of eminent domain raises very serious legal and constitutional issues,” the letter said. “It would also be immensely destructive to U.S. mortgage markets by undermining the sanctity of the contractual relationship between a borrower and creditor, and similarly undermining existing securitization transactions.”

The letter doesn’t actually go on to outline those “very serious” legal issues, so, at the suggestion of coalition member Chris Katopis of AMI, I reached out to Marko Mlikotin of the nonprofit California Alliance to Protect Property Rights. Mlikotin, whose group recently sponsored an unsuccessful ballot initiative to curb state and local government rights of eminent domain in California, spoke eloquently about what he considers a dangerous abuse of power in the mortgage seizure plan. “San Bernardino has embraced the view that the government’s power of eminent domain has no boundaries,” he said. If a city can condemn and seize mortgage loans in the name of the public good, Mlikotin said, what’s to stop it from exercising eminent domain over pension fund obligations to public employees? There’s certainly an argument to be made that a takeover of those obligations would benefit the broader public. According to Mlikotin, any intangible asset is up for government grabs if San Bernardino is allowed to seize securitized mortgage loans. As another critic of the eminent domain plan, law professor Anthony Sanders of George Mason University, told me in an email, “Eminent domain has been used to seize land for public improvements such as railways, highways and public building projects. It was never intended to seize securities and debts. If this is allowed, we have crossed the line.”

But here’s the thing: Courts have long since crossed that line, according to Cornell law professor Robert Hockett, who wrote a 55-page paper that provides the structural and legal underpinning of the San Bernardino plan. (Hockett also wrote a much shorter Reuters op-ed on the issue; he told me he was hired by Mortgage Resolution Partners to research the legality of exercising eminent domain over private mortgage loans but has not been paid by San Bernardino.) To begin with, Hockett pointed to the U.S. Supreme Court’s 2005 opinion in Kelo v. City of New London, which held that New London, Connecticut, had the right to seize property on behalf of a private developer because the developer’s urban renewal plan was in the public interest. The controversial Kelo ruling has been a scourge of private property rights activists, but it’s the foundation of San Bernardino’s eminent domain plan; according to Hockett, San Bernardino’s proposed exercise of eminent domain is much easier to justify as a public benefit than New London’s in the Kelo case.

Hockett also pointed to federal and California precedent for eminent domain seizure of intangible property, as long as the public benefits. “Under the federal rendition of this authority, for its part, the U.S. Supreme Court and the Courts of Appeals have regularly held that the authority extends, for example, to contract rights, insurance policies, shares of stock, businesses as going concerns, hunting rights, rights of way, and all manner of additional intangible [assets],” Hockett asserted (with citations). “U.S. states follow the same longstanding common law tradition as does federal law in this connection. California’s Supreme Court, for example, long has explicitly recognized that ‘[the state's] eminent domain law authorizes the taking of intangible property.’” In one of the most notable California cases Hockett cited, a state appeals court said the Oakland Raiders football franchise was subject to an eminent domain seizure.

In an interview Wednesday, Hockett conceded that the eminent domain seizure of a mortgage loan has apparently not been tested explicitly in court. But he said that’s because before the unique circumstances of the housing bubble, governments never had reason to condemn mortgages for the public good. Courts have approved the seizure of plenty of other securities and liens, he said. “Eminent domain applies to any kind of property, period,” he said. (His paper, moreover, cites a 1993 Nebraska Supreme Court holding that “a mortgagee’s lien on real estate is an interest that may be subjected to a taking for a public purpose and, therefore, may be the subject of an eminent domain proceeding.”)

The only possible complication, according to Hockett, could be jurisdictional because the owners of the seized mortgages – i.e., the MBS investors – don’t necessarily reside in the same place as the mortgaged property. But that’s an arcane analysis very unlikely to sink the San Bernardino plan.

Hockett told me that the constitutional gauntlet thrown down by the industry groups opposed to the eminent domain plan seems to him to be a negotiating tactic in the eventual fight over the fair value of the seized mortgages. “The fact that those groups came out so early on told me they’re not really convinced [that there are legal problems with the plan] but are engaged in haggling,” he said. “This is a kind of kabuki-theater haggling over price.”

I found Hackett’s analysis very convincing, especially because he told me he spent five or six weeks researching the legality of eminent domain seizure of mortgage loans. But I’ll give the last word to an opponent of San Bernardino’s plan, who is just beginning his examination of its constitutionality: Anthony Caso of the Chapman University School of Law and the Center for Constitutional Jurisprudence, to whom California property rights activist Mlikotin sent me. Caso told me he believes there’s a key legal difference between mortgage loans and ordinary securities because mortgage notes include a continuing contractual obligation to pay off the loan.

Under the U.S. Constitution’s Contract Clause and California’s even more stringent state version of the contracts provision, governments may not interfere with private contracts except in extreme circumstances. Caso said there’s a good argument that San Bernardino’s plan to use eminent domain conflicts with the Contract Clause.

What about all of the precedent approving eminent domain seizures of other liens? I sent Caso Hockett’s paper, and he sent back an email: “None of the cases cited by Professor Hockett concern an attempt to condemn a mortgage interest,” he said. “That government is prevented from destroying the value held by the lien holder without paying damages does not permit the government to condemn the note and deed of trust simply so that it can turn a quick profit … Both the California and U.S. Constitutions forbid state and local entities from impairing the obligation of contracts – this restriction on power is separate from the obligation to pay just compensation when government destroys property.” I have a feeling we haven’t heard the end of this debate. Stay tuned.

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14 comments

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All investment carries risk. Eminent domain in this case seems to definitely be for the public good (investors are investors – not part of the public in this sense). So, if this application of eminent domain is upheld as legal, it will be a good way for ailing communities struggling with an inordinate number of underwater properties to “right the ship”, so to speak. Yes, it is too bad investors in bundled mortgages will lose out, but the banks, financial institutions, and regulators did not seem to get too upset over the underlying Goldman Sachs fraud in bundled securitized mortgages, nor did anyone get too upset when other frauds and misconduct affected the property values and retirement savings of millions of americans. So, San Bernadino, if it is legal, go for it.

Posted by JBGJRESQ | Report as abusive

NPR recently did a story (here: http://www.npr.org/blogs/money/2012/07/1 0/156573630/episode-385-how-good-governm ents-go-bad#more)

In this story, they compare US governance to Italy. In Italy, increasingly populist legislation was coupled with special favors to industries targeted by legislation. The cycle of regulation and exceptions lead to distrust in government because it gave the appearance of favors.

As a citizen, Kelo taught me that the government can take ownership of my house if it will lead to the possibility of an improved local economy. I think it will be extremely unfair if the government cannot take ownership of my house from the lien holder for the same reason.

Posted by spillsoup | Report as abusive

As I recall from research I did during a course in Graduate school, eminent domain law applied to New York State real estate required that the city or state condemn whole neighborhoods. They could not cherry pick the blighted from the adequate. It was a question of equal protection under the law. That was not unique to NYC practice either.

I tend to agree with Anthony Caso that San Bernardino is moving way over the line. Theirs isn’t a case where the physical condition on the property has deteriorated to slum conditions or that a neighborhood has suffered from decades of under-investment. The city is not proposing to replace the underwater real estate with better-priced and perhaps smaller and less ostentatious housing or more appropriate public housing. It may very well be that mega houses are being taken as well as more modest homes. Landlords or an owner being caught in real estate with declining value isn’t unique to this decade. The city is trying to make the case that people who paid too much for their homes are therefore “blighted” and causing a public health and safety issue for the larger city. If they can do that – what can’t they decide to take if enough very vocal citizens what them to take it? Being caught is a trap created by an over ambitious real estate market is not exactly the same thing as living in squalor or grossly inadequate neighborhoods or buildings.

Most eminent domain takings require that the city buy the structures that it seeks to improve or replace and San Bernardino will apparently do the same thing for structures it will than turn around and resell as quickly as possible? In the old days the property owners would be storming the city hall with tar and feathers to throw the bankers out of City Hall.

And unlike public infrastructure improvements that do benefit a much larger public, it is hard to see how getting people out from overpriced mortgages benefits more than themselves? The city can’t also reasonably say that the taxable valuation of the property is larger, can it? San Bernardino’s actions don’t even agree with the SC decision re: New London because the SC agreed with New London that it was in the public interest to allow private redevelopment of property taken through eminent domain to “INCREASE PROPERTY VALUES AND THE TAX BASE. San Bernardino’s use of eminent domain powers will actually be doing the reverse and making the neighborhood less expensive (unless somehow the taxable valuation of the property and the market value live in vastly different, even contradictory worlds?

I am sure the argument isn’t over but I am beginning to wonder if even the Supreme Court believes its arguments anymore. They still haven’t posted the ACA written decision on their website. I really wanted to read the whole document – all the opinions – and can’t seem to find a copy online.

Posted by paintcan | Report as abusive

Paintcan: Regarding your last comment, sorry to report no conspiracy theory to be found here. The ACA decision is easily found on the SCOTUS web site. Look under the “Opinions” tab, “Latest slip decision.” Third from the top, docket 11-393. As with all slip decisions, its posted the day the decision is announced…

Posted by HerrCIO | Report as abusive

paintcan — Based on Ms. Frankel’s description above, San Bern is not proposing to sieze any physical property. They are siezing the mortgages.

Posted by Sanity-Monger | Report as abusive

“Yes, it is too bad investors in bundled mortgages will lose out, but the banks, financial institutions, and regulators did not seem to get too upset over the underlying Goldman Sachs fraud in bundled securitized mortgages”

@JBGJRESQ
You realize of course that the owners of those MBS are now pension funds and 401K funds with companies like Fidelity and Vanguard. So, you are prepared to raid the retirement funds and pensions of these innocent investors in order to help out real estate speculators in San Bernardino?

There is plenty of blame to go around. However, attacking the mortgage backed securities at this point will have little to no impact on Goldman Sachs and the like. In fact, part of the problem with mortgage securitization is that the originators carry little to no long term risk (no skin in the game) from their products.

As for not being upset, it appears that Fannie-Mae and Freddie-Mac are upset enough to demand mortgage repurchases at “unprecedented levels”.

http://www.insidemortgagefinance.com/iss ues/imfpubs_imf/29_25/news/FHFA-GSE-Buyb ack-Policy-Transparency-1000020010-1.htm l

Even if it were legal, eminent domain should not be used in this way. If we start nullifying contacts for less and less reason, then we are no longer a nation of laws. Have you ever noticed how poverty and despair are most rampant in places where laws and contracts are not enforced?

Hopefully, the courts in CA will deal with this accordingly.

Posted by alignedinterest | Report as abusive

Maybe we think it shouldn’t be used, but that doesn’t mean they can’t. There is no question that it will raise property values, in accord with eminent domain, because of those who are underwater, some will default and be foreclosed. If you don’t think that drops property values you haven’t been paying attention these past years. It is just like saying, “if we don’t build a highway, these properties will languish in value.”

Additionally, who says investors have the right to never lose money? You make a bad loan, it can’t be payed back, you take a haircut. NOTHING is inherently sacrosanct about debts. If it is pension funds that lose out, they have the right to sue those who bundled the securities, and probably others too. Messy its true, but arguably a lot less messy than what is happening now.

Posted by Benny27 | Report as abusive

@sanitymonger- If the city is planning to “take” the mortgages (for fair market value)that means they have the deed to the property. That’s the collateral.

I hope the city doesn’t have an easy time trying to implement this program.

alignedinterest raises the prospect that big multi property investors may be most avid for relief? Do commercial mortgages qualify: eventually if not now?

Posted by paintcan | Report as abusive

Eminent domain (ED) is almost never ruled dysfunctional like the other “ED” by the courts.

ED gets a pass by the courts just like Roberts gave Obamacare a pass, ties go to the Government.

Sad fact is that 99% of all ED takings have never been for a valid public good or purpose, almost all are based upon the whimsy of politicians, developer bribes of politicians, gifts to railroads, gifts to China etc. So do you honestly believe that any form of property is safe? There are no property rights whatsoever in the U.S. only “hope” that springs eternal.

Posted by JP007 | Report as abusive

Every time, it is the taxpayer who ends up holding the bag and the bankers who laugh all the way to … the bank. This will almost certainly turn out the same way every other “bailout” has turned out. The common people lose and the banks win. Time after time after time.

No more insurance for banks! The only deposit insurance should be for Credit Unions (which must be non-profits). Why insure idiotic loans? Federal insurance should only protect people, not “corporations” or other types of “association”. And it should not protect anything but deposits below a reasonable value, say $250,000. Every other “guarantee” has been turned into a blank check on the treasury by wealthy crooks.

Posted by usagadfly | Report as abusive

@alignedinterest

You realize of course that if we don’t get our economy back on track, it would very well collapse which would leave pension funds and 401K funds destitute and it just might unravel the social fabric on which we all depend for a normal life.

I take issue with your characterization of people who are still making timely payments on their underwater mortgages as real estate speculators. The real estate speculators walked away as soon as it was clear that property values were in a tailspin.

The people who are continuing to make payments at this stage are people who bought their homes intending to live there… and they are. They are the salt of earth, people with jobs and families, who put most of the cash they managed to slowly accumulate during their lives as a down payment on their home only to watch it evaporate due to irresponsible lending practices and money games on Wall Street.

They are precisely the people who should be made whole and since the federal courts have been unwilling to take action against the silk-suited bandits, being able to repurchase their homes at fair market value through eminent domain seizures is the only justice those ordinary people will ever have.

Once those homeowners have recovered from their immense financial losses, they will resume spending and our economy just might have a chance to get some legs.

Posted by breezinthru | Report as abusive

Its clear that something needs to be done to address the household balance sheet issue in the country; the lack of improvement in that area has been a continued drag on the economy by depressing demand, in contrast to the improvements seen on the corporate side, which would also benefit significantly from a household balance sheet clean up. That said, if San B’s strategy disrupts the MBS market significantly, which i fear likely would, it would result in decreased credit availability for would-be homeowners, it would be a self defeating plan as housing prices could decline further or remain stagnant well into the future. I do not have an alternative plan, but I hope someone with the expertise in this area that I do not have is able to find a workable solution.

Posted by NoVaCRE | Report as abusive

@NoVaCre

Yesterday’s Reuters article about Citi’s continuing saga of misfortune attributes the recent big losses to MBS generated in the several years before the collapse, so the MBS market is already losing money. Decreased credit availability for would-be homeowners is already a problem and has been for the past several years.

Even though negotiating a workable alternative to default is in the interest of both parties regarding mortgages that are deeply underwater, the ‘two parties’ can’t negotiate a payment strategy that both parties are willing to live with MBS’s created a situation where there is no 1:1 correspondence between the party that owns the mortgage and the party that is making payments on it.

In the brave new world created by MERS, the mortgage servicer is seldom the sole owner of the mortgage.

Most people who are still making timely payments on their deeply underwater properties… like me… will eventually default if no resolution is found. My 50K down payment is gone, the principal portion of my monthly payment is gone before I even “write the check” each month and 15K that I put into improvements when I bought my modest rambler in 2006 is also gone. I planned to live here until retirement in 2019. I intended to sell at that point because I can’t afford these payments on my projected retirement income, but I can’t sell and come anywhere close to breaking even.

I and millions more homeowners like me will eventually default if no resolution is found. A principal reduction to fair market value now won’t enrich me, but it would allow me to sell and at least break even at some point. That removes the incentive to walk away.

Posted by breezinthru | Report as abusive

@HerrCIO – I found a text in the NYT yesterday afternoon before I saw your comment and after I had done a more general online search.

I didn’t mean to suggest a “conspiracy”. If one does a docket search at the SC site it comes up empty. These sites still confuse me.

Obviously – not every Justice on the SC believes the arguments presented by every other Justice. Having difficulty finding the text made me think that perhaps they didn’t consider it one of their shining achievements? A silly notion I suppose but the more I read it the more I can see that may well be the case. Justice Scalia seems to think it wasn’t one of their better decisions.

I haven’t read the New London case but I won’t be surprised if that isn’t all that fine a piece of reasoning either. I have read that many municipalities have already attempted to protect themselves from some of the implications of the New London decision. But that’s the next read.

BTW -Thomas’s opinion at the end of the text re: the commerce clause is so brief it looks to me like it is missing most of the argument he is trying to make. But ag after p 193 there were no more pages.

As Scalia criticized the ACA, it is possible that the New London decision will/is breeding more constitutional problems than it might solve.

Maybe this issue will go to the SC too and the court could have a chance to reconsider the New London decision. Perhaps Congress may have to redefine the issue of eminent domain and put very well defined limits on it because this idea of claiming that private indebtedness (most of whom are probably more recent home buyers) is a public issue is a bit of a stretch, to say the least.

Posted by paintcan | Report as abusive