City attempting to seize underwater mortgages via eminent domain: constitutional objections, potential investor losses

by DLA Piper

The City of Richmond, California has commenced the process for taking by eminent domain hundreds of notes secured by mortgages on underwater residential properties owned by investors through residential mortgage backed securities (RMBS).

This is the first time a government entity has implemented a novel concept that some law professors1 and a for-profit company2 have been advocating and shopping to many local governments as a solution to the mortgage crisis.

Rather than waiting to defend individual eminent domain actions in state court, last week bank trustees of many RMBS sued in federal court in San Francisco to stop the City’s seizure program.3

The City’s legal strategy is based on California and federal law that allows use of the eminent domain power to condemn intangible property, such as a note secured by deed of trust, if the condemnation is for a valid public use.4

Richmond claims its purpose is to ameliorate the effects of the ongoing financial crisis, particularly home foreclosures and associated urban blight, by seizing and writing down existing mortgages, then refinancing the loans for resale at a lower principal amount to new private investors.  The City attempts to expand on the recent US Supreme Court decision in Kelo v. City of New London, which approved the use of eminent domain even when it directly benefits another private entity.

Richmond’s strategy depends on purported benefits arising from the aggregate of individual private mortgage write-downs rather than a specific need and resulting public benefit for the taking of any particular mortgage.  The City’s plan is to use the eminent domain power to seize underwater residential loans; pay “just compensation” at substantially less than the current sub-par value of the real property security; and then attract private capital to re-issue new loans to the homeowners at greatly decreased principal amounts.

The City has primarily targeted  performing loans because those are the loans most attractive to new investors.  However, some observers have noted that such borrowers are the very people who are most likely to pay off their loans per contract and are least likely to need mortgage relief. 

Scene of the national battle

Because this is the first time a municipality has ever commenced such a legal process and initial lawsuits have now been filed in federal court in San Francisco, the national battle over the constitutionality of seizure programs will take place in the Northern District of California.   Absent  a state or federal legislative solution that says the City’s program is outside the bounds of eminent domain, the legality of the City’s Seizure Program will be determined in federal court.

Bank trustees’ arguments

The federal court lawsuits by three bank trustees (Wells Fargo Bank, Deutsche Bank and BNY Mellon) argue that the City’s plan should be enjoined because it violates:

  • the Takings Clauses of the US and California Constitutions, because it is not a valid “public use” of eminent domain, even under the expansion of “public use” found in Kelo v. City of New London
  • the Takings Clauses of the US and California Constitutions, because it is an attempt to exercise extraterritorial eminent domain jurisdiction by seizure of notes that are not within the City and are owned by out-of-state RMBS
  • the Commerce Clause of the US Constitution, by disrupting interstate commerce in mortgage financing
  • the Contracts Clause of the US Constitution, by wrongfully impairing private contractual obligations between note holders and the homeowner borrowers, most of whom will continue to pay per contract on home mortgages that are temporarily underwater
  • the Just Compensation Clauses of the US and California Constitutions, by not paying the fair market value of the notes (which are performing loans, even though the real property security is currently underwater)
  • the Equal Protection Clauses of the US and California Constitutions by cherry-picking mostly performing (and therefore readily marketable) loans for seizure and targeting only those loans owned by RMBS trusts
  • Cal. Code. Civ. Proc. Section 1240.030 as a matter not in the public interest and necessity, nor planned in a way most compatible with the public good and least public injury, nor necessary, and
  • the California Constitution, by taking a private residence for the purpose of conveying to a private person.

BNY Mellon further argues that the City’s plan constitutes tortious interference with a contract, by interfering with currently performing loans between homeowners and note holders.

The Seizure Program affects investors, title companies, mortgage lenders and many others

Beyond just bank trustees, this program will impact institutional investors such as insurance companies, pension funds and mutual funds, which own significant amounts of RMBS, and which therefore stand to take large losses.

The program also poses huge questions for the FHFA, Fannie Mae, Freddie Mac and title insurance companies.  If the City were successful in seizing and re-writing residential loans secured by mortgages, and if the matter were to remain in legal limbo until resolved on appeal, who would be the owners of the right to be paid on the notes, and of the liens on real property security: the holders of the old notes tied up in litigation, or of the new notes issued pursuant to the Seizure Program? Would title companies issue title insurance on the new loans?

In addition to direct losses to investors in RMBS and chaos for FHFA, Fannie, Freddie and title companies, widespread use of eminent domain to seize residential mortgages could cause significant disruption in the credit markets, including increased costs and/or loss of credit to home purchasers in cities exercising eminent domain to seize underwater mortgage loans.

Taking appropriate steps

Beyond the constitutional questions, there are significant statutory processes applicable to each affected mortgage.  The City has issued offer to purchase letters to 32 holders of RMBS involving over 600 individual mortgages, which is the first step in the eminent domain process.  The letters offer to pay “just compensation” for the mortgages at well below the already below-par “fair market value” of the residential properties that secure the loans.  Recipients of the letters have a short time to respond, and, if the offers are rejected, the City will proceed with condemnation of the affected mortgages.

Investors should take care to ensure that the trustees of the RMBS trusts in which they have invested are taking appropriate steps to challenge the City’s efforts.  In addition to preemptive legal challenges such as the lawsuits described above, trustees can also directly object by appearing at the City Council meetings regarding resolutions of necessity – a prerequisite to the exercise of eminent domain, making writ of mandate challenges to such resolutions if adopted, and defense of eminent domain proceedings on the issues of “right to take,” “just compensation” and numerous statutory requirements.  If the City’s Seizure Program is not enjoined, then investors with actual or potential RMBS exposure, including any investor which received an offer to purchase letter from the City, must object (or cause the RMBS trustee to object) to the eminent domain proceedings to prevent the takings.

Besides direct legal action by their trustees, major investors in RMBS and title companies, mortgage lending and real estate businesses, trade groups or other affected businesses should consider amicus curiae participation now in the pending challenges to the City’s plan at the initial pleading stage of the litigation.  Investors and others should also consider advocacy in support of state and/or federal legislative intervention and also before state and local governments, wherever municipalities are considering following the City’s lead.

If the City’s eminent domain efforts succeed, then other cities are likely to initiate similar proceedings in California and across the country.  Most cities to which this proposal have been pitched have rejected it, including Chicago and, in California, a consortium of San Bernardino and other Inland Empire cities with distressed real estate values.  However, a number of cities, among them Newark, New Jersey; Seattle, Washington; El Monte, California; and North Las Vegas, Nevada, have reportedly engaged Mortgage Resolution Partners or are considering similar programs.

1 See, e.g., Robert Hockett, “Paying Paul and Robbing No One: An Eminent Domain Plan for Underwater Mortgage Debt,” 19(5) Current Issues in Economics and Finance 1 (2013); Ngai Pindell, “Nevada's Residential Real Estate Crisis: Local Governments and the Use of Eminent Domain to Condemn Mortgage Notes,” 13 Nev. L.J. 888 (2013); Robert Hockett, “It Takes a Village: Public-Private Partnerships for Write-Downs of Underwater Mortgage Debt,” 18 Stanford Journal of Law, Business, and Finance 121 (2012).

2 Mortgage Resolution Partners, L.L.C., formed by former lawyers and bankers as a for-profit venture.

3 Wells Fargo Bank, N.A. v. City of Richmond, No. 13-cv-3663 (N.D. Cal.); Bank of New York Mellon v. City of Richmond,  No. 13-cv-3664 (N.D. Cal.). 

4 City of Oakland v. Oakland Raiders, 31 Cal. 3d 656 (1982), Kimball Laundry Co. v. United States, 338 U.S. 1 (1949).


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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