Planned Use of Eminent Domain Powers to Condemn Underwater Mortgages Faces Uncertain Constitutional Outcome

by Jeffer Mangels Butler & Mitchell LLP

Amidst reports of rising home prices throughout California and fears of a new housing bubble, controversial plans floated by California cities to deal with the lingering effects of the mortgage meltdown by invoking their powers of eminent domain are gaining traction. The City of Richmond in Northern California has begun implementing the plan by sending letters to hundreds of holders of underwater mortgages -- mortgages on homes that are now worth less than the mortgage amount -- offering to purchase the loans at a discount. If the mortgage holders refuse, Richmond's mayor has indicated that the city will move to seize the loans pursuant to its eminent domain powers.

The idea came to national prominence last year when the County of San Bernardino combined with the cities of Ontario and Fontana to form a Joint Powers Authority to publicly examine proposals to assist homeowners within their jurisdictions who are underwater on their mortgages. The JPA publicly flirted with the use of eminent domain to seize underwater mortgages only to abandon the idea after opposition surfaced.

The Los Angeles Times reports that the City of El Monte is considering adopting a similar plan. Other cities across the country and throughout California, including La Puente, near El Monte, and Orange Cove and San Joaquin in Fresno County, are reportedly doing the same.

Details of the Richmond Plan

An article in the New York Times, explains the City of Richmond's plan as follows:

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.

Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program. The $30,000 difference goes to the city, the investors who put up the money to buy the loan, closing costs and [a private investor firm]. The homeowner would go from owing twice what the home is worth to having $10,000 in equity.

The mortgage seizure plan has understandably drawn a number of critics. Mortgage and investment professionals have denounced the plan variously as short-sighted, dangerous and ultimately counter-productive. A statement issued by the Securities Industries and Financial Markets Association (SIFMA) declares that the plan "will hurt many more homeowners both within the city and around the country than it is alleged to help." The plan will raise borrowing costs and may restrict credit, according to the statement.

Beyond such practical effects, there are serious doubts regarding the legality of Richmond's mortgage seizure plan and whether it is consistent with constitutional and other limits upon the government's use of eminent domain. At a minimum, should Richmond, El Monte, or any other California city, go forward and actually begin seizing underwater mortgages, years of litigation are sure to follow. Indeed, two preemptive lawsuits have already been filed: one by Well Fargo and another by New York Mellon on behalf of their respective trusts. As these cases make their way through the court system, the following issues will loom large.

Is the Richmond Plan Constitutional?

The Fifth Amendment to the U.S Constitution provides that "private property" shall not "be taken for public use, without just compensation." From the text of the amendment, two general limitations upon government's use of eminent domain arise. One, the government may take private property only when the taking is for a "public use." And two, prior to the taking, the property owner must be paid "just compensation." The legality of Richmond's mortgage seizure plan must therefore be tested under these twin constitutional restraints.

Public Use

While there is little question that the government may lawfully condemn intangible property such as a mortgage (See City of Oakland v. Oakland Raiders, 31 Cal. 3d 656 (1982) [affirming right of California city to acquire professional football team by eminent domain]), there are serious questions as to whether Richmond's mortgage seizure plan is made pursuant to a valid public use. Perhaps the most relevant authority is the United Supreme Court's much maligned opinion in Kelo v. City of New London, 545 U.S. 469 (2005). The Kelo Court declared it "perfectly clear" that "the sovereign may not take the property of A for the sole purpose of transferring it to another private party B, even though A is paid just compensation." Id. at 477. The Court, of course, famously sidestepped that "perfectly clear" constitutional limitation and upheld the right of the City of New London to take private homes for the purpose of transferring them to a private developer for redevelopment.

There is certainly at least a plausible argument that the holding of Kelo would extend to affirm the right of the City of Richmond to take underwater mortgages given the expected public benefit of preventing further foreclosures and aiding the local economy, but the conclusion does not necessarily follow. Kelo involved an "integrated development plan" formulated pursuant to a comprehensive planning scheme designed to revitalize a specific blighted area. The nexus between New London's eminent domain activities and the constitutional requirement of a public purpose is therefore arguably more direct than the general economic benefits espoused by proponents of Richmond's plan. In fact, should Richmond's plan pass constitutional muster, it is difficult to conceive of any real limitations upon the government's power to take one person's property and give it to another so long as the latter could rationally be said to have greater capability to put the property to more productive use.

Just Compensation

But even if the mortgage seizure plan is deemed a "public use" in the constitutional sense, questions of just compensation may ultimately derail it. The "just compensation" clause requires a condemning agency to pay the property owner "fair market value" of the condemned property and in California that means the highest amount that a hypothetical buyer and seller would agree to, neither being under any particular necessity for buying or selling. Cal. Civ. Proc. Code § 1263.320(a). Taking the New York Times description of the Richmond plan on its face, it appears to suffer from a fatal flaw: a faulty assumption regarding the value of the $400,000 mortgage. Indeed, implicit within the New York Times description is the notion that the value of the mortgage had decreased in lockstep with the value of the home. But that would only be true, at least conceptually, if the risk of default was 100%, which surely is not accurate, especially considering that Richmond's plan calls for taking only currently performing mortgages. Assuming the risk of default is much less - say a more believable 25% - the fair market value of the condemned mortgage may be substantially more than the hypothetical $200,000 home value. Ultimately, having taken the mortgage, the City of Richmond may find itself being forced to pay the mortgage holder substantially more than the current value of the mortgaged home, and along with it, the mortgage holder's attorneys' fees.

Concluding Thoughts

These are just two of the issues that the City of Richmond faces. California state law also imposes limitations upon a city's use of eminent domain that may thwart Richmond's plan. Mortgage holders will also likely raise additional constitutional arguments based upon the Commerce Clause (regarding a city or state's interference with interstate commerce) and the Contracts Clause. While it is unclear how these issues might ultimately play out, the level of opposition and criticism the plan has already drawn ensures that protracted litigation is sure to follow.

This article, written by Matthew Hinks, was first published by Law 360.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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