Mortgage investors’ inevitable constitutional challenge to eminent domain
On Tuesday, the small California city of Richmond announced that it has sent notices to 624 homeowners whose houses are worth less than they owe on their mortgages. Richmond said it intended to buy their mortgages for 80 percent of the fair value of their houses and to help them refinance with new, more affordable mortgages. In the event homeowners don’t want to participate in the program, Richmond said it would use its power of eminent domain to seize the mortgage loans.
Yes, the much-discussed eminent domain mortgage seizure idea is finally being realized, despite vehement opposition from just about the entire financial industry. It’s been more than a year since a San Francisco outfit called Mortgage Resolution Partners first floated the concept of partnering with troubled cities to reduce foreclosures by using the city’s eminent domain power to seize mortgages of underwater homeowners in the name of the public good. (MRP’s role is to provide cities with capital for the eminent domain purchases, issue modified mortgages to homeowners and then bundle and resell the new loans as mortgage-backed securities.) Proponents have pitched the plan as a public boon, a way to keep homeowners in their houses and preserve neighborhoods that would otherwise be blighted with foreclosures. The concept was alluring enough that over the last year, officials in several California cities, as well as North Las Vegas and even Chicago, have toyed with using eminent domain to stave off foreclosures.
Before Richmond, however, all of the cities that considered the scheme have been dissuaded, in part by concerted financial industry opposition. Investors in mortgage-backed securities hate the eminent domain idea. No mystery there: The vast majority of the mortgage loans that cities want to seize belong to MBS trusts. When cities talk about buying mortgages for 80 percent of the current value of a house, they’re not accounting for the value of the seized loan to the MBS trust that actually owns the mortgage, especially because these eminent domain proposals call for the takeover of performing loans, not mortgages on which homeowners have already defaulted. (More than 440 of the homeowners that received notices from the city of Richmond are up-to-date on their mortgage payments.) So as Timothy Cameron, the head of the Asset Management Group of the Securities Industry and Financial Markets Association, explained to me on Thursday, MBS investors believe that they’re twice injured by mortgage seizures under eminent domain plans. First, they’re shortchanged on the value of the revenue stream from a performing loan; and second, they’re damages by the decline in the value of their mortgage-backed securities, which are worth less when performing loans are terminated.
So what, if anything, can MBS sponsors, trustees and investors do to stop Richmond’s eminent domain plan now that it’s under way? They can sue! In fact, SIFMA, the American Bankers Association, the Association of Mortgage Investors and other major industry players have been hinting at litigation for almost as long as eminent domain proposals have been circulating. I’ve previously written about the legal underpinning of the eminent domain mortgage seizure idea, explaining that the U.S. Supreme Court’s 2005 ruling in Kelo v. City of New London provides strong support for the principle of eminent domain seizures that benefit private entities along with the public. There’s also precedent for the eminent domain seizure of intangible property such as contract rights or insurance policies, including a 1993 Nebraska Supreme Court decision that said a mortgage lien could be subject to eminent domain.
But at the time I wrote that piece, opponents hadn’t yet put forth cogent legal arguments for why the proposed mortgage seizures run afoul of the Constitution. They’ve since issued explanations, notably a comprehensive white paper that O’Melveny & Myers wrote last July for SIFMA and a shorter (though still helpful) eminent domain analysis Jones Day published last June. With eminent domain litigation looking increasingly inevitable, I thought it would be a good time to look at the arguments opponents are likely to make.
The threshold issue will almost certainly be whether eminent domain seizures of mortgages on underwater homes are a public use, a necessary condition for the government to take private property. Certainly, there’s a public use in saving neighborhoods from a rash of foreclosures. But would mortgage seizures do that? When a government seizes property in order to, say, build a bridge, chances are very good that the bridge will be built, justifying the public use of eminent domain. It’s much less clear that mortgage seizures will keep individual homeowners in their houses. Moreover, as O’Melveny argues in the SIFMA white paper, the public benefit of widely scattered mortgage seizures is much less discernable than an integrated development plan.
That’s how opponents of eminent domain mortgage seizures can distinguish plans such as Richmond’s from the property seizure the Supreme Court approved in the Kelo case. There the justices said the City of New London could take control of property that Pfizer intended to develop as a research facility because the seizure was part of an integrated development plan that was reasonably certain to relieve urban blight. House-by-house mortgage seizures, O’Melveny argued, have a much more haphazard impact and might not meet the public-use standard of Kelo. (There are also policy arguments for why Richmond residents would be harmed by rather than benefit from eminent domain seizures, which would make institutional investors reluctant to assume the risk of buying future securitizations that contain mortgages on homes in Richmond, thus making it more difficult for Richmond residents to obtain mortgages. But that’s not a legal argument.)
Mortgage investors or MBS trustees might have standing to argue that Richmond’s plan does not satisfy the public-use requirement before the city actually proceeds with a seizure. But if they can’t block takeovers from taking place at all, they can deploy at least two constitutional arguments for why they’re illegal. One involves the Fifth Amendment right to just compensation for the government’s taking of private property. As SIFMA’s Cameron explained above, the value to MBS investors of a performing loan in an MBS trust is not the same as the value of the actual home. Paying 80 percent of the house’s value, as Richmond says it intends to do, may not be just compensation. If it’s not, Richmond is in violation of the Fifth Amendment.
The Contracts Clause may also be a problem for eminent domain proponents. The clause, as the O’Melveny memo explains, was included in the Constitution because states were attempting to relieve residents of their obligations to foreign lenders after the Revolutionary War. The clause prohibits states from interfering with private contracts unless there’s a “significant and legitimate public purpose.” Eminent domain opponents could assert that Richmond’s seizure is precisely the sort of improper state attempt to help citizens dump debt that the Framers intended to preclude because the seizures don’t have a clear public utility.
There are other arguments against eminent domain mortgage takeovers, including state constitutional concerns. The public use, Fifth Amendment and Contract Clause issues seem to me to be the most potent, although it will be tough to overcome the Kelo precedent. I’m eager to see MBS investors kick off the attempt.
(Reporting by Alison Frankel)
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