alerts & publications
The Use of Eminent Domain to Write Down Mortgage NotesSeptember 5, 2012
Recently, the Securities Industry and Financial Markets Association (SIFMA) publicly released a legal memorandum prepared by O’Melveny & Myers LLP articulating potential legal and practical problems with the proposal currently being considered by the San Bernardino Joint Powers Authority (JPA) and the City of Chicago to seize mortgages on underwater properties and write them down. Since the release of the memo, the Federal Housing Finance Agency (FHFA) has issued a statement expressing concerns with the proposal. Yet the JPA passed a resolution August 16th authorizing the preparation of a request for proposal seeking formal proposals to address issues related to underwater mortgages and foreclosures and to promote home ownership. As other municipalities consider similar issues, the legal issues raised in O’Melveny’s memo are sure to be at the forefront of all related discussion and ensuing judicial challenges, should such a proposal be adopted. The full memo can be found here.
The Issue: The County of San Bernardino, in conjunction with the cities of Fontana and Ontario, formed the JPA to consider a proposal from Mortgage Resolution Partners LLC (MRP), whereby municipalities would use their eminent domain authority to seize performing underwater mortgages from private securitization trusts. The securitization trusts would reportedly be paid for each mortgage an amount approximately 20-25% less than the current market value of the property securing the loan. The mortgages would be refinanced at slightly less than the current market value of the properties and would be repackaged into new securitized trusts. The O’Melveny memo concludes that the proposal is subject to attack on numerous grounds.
First, the memo opines that the seizure would be subject to attack as an impermissible taking under both the United States and California Constitutions. Specifically, it is highly questionable that the transfer of mortgages from one private securitization trust to another is a seizure of the mortgages for “public use.” This is particularly so given the substantial and direct benefits that the scheme delivers to private entities: chiefly those that purchase the performing mortgages at a deep discount and borrowers who received principal reductions. The stated public benefit of the plan—to minimize foreclosures—is diminished because only performing loans are eligible for the MRP program. Mortgages securing loans already in default, or properties already being foreclosed upon, are not eligible. The memo further explains that the program would likely not confer the intended public benefit of increasing home ownership, both because only performing loans are eligible for the program and because approval of the program might result in decreased lending in areas that have adopted the program.
The plan to compensate mortgage owners at approximately 20-25% less than the current market value of the property securing the loan also raises substantial constitutional concerns. As outlined in the memo, there are obvious grounds to question whether this measure of payment meets the constitutional requirement for providing “just compensation” (i.e., fair market value) for the mortgages. Paying between 75% and 80% of the appraised value of the properties securing the loans is a significantly smaller percentage of the face value of the notes given that the plan only extends to underwater mortgages. The memo suggests the discount may be deemed unjustified, particularly given that all loans that would be seized are performing loans. Moreover, it is the value of the notes, not the properties securing them, that must be evaluated. Additionally, the value of the notes is impacted by the fact that they are securitized. The trusts must be compensated for any damage they suffer as a result of the removal of the performing loans.
Second, the memo explains that the proposed plan is subject to attack as violating the Contracts Clause of the U.S. Constitution. Under Supreme Court precedent, abrogating the current note owners’ contractual rights “substantially impairs” the contracts. For the same reasons, the plan may be said to lack a public purpose. Courts will have serious doubts about whether MRP’s proposal serves a legitimate and significant public purpose, as opposed to serving the interests of MRP and its investors, as well as those of the narrow class of indebted homeowners with underwater but performing loans.
Third, the memo articulates that the MRP proposal is subject to attack for violating the dormant Commerce Clause of the U.S. Constitution in at least two related respects. The proposal would permit the JPA to seize notes held in trusts outside the state of California—which can be seen as a direct regulation of out-of-state property with a potentially sweeping extraterritorial effect. But even to the extent the MRP proposal does not directly regulate out-of-state property, it imposes major burdens on out-of-state property and transactions by decreasing the value of securitized trusts by removing pools of performing loans from the trusts.
In addition to the potential constitutional challenges to MRP’s plan, the plan is subject to other legal attacks. Specifically, the plan could be said to violate San Bernardino County’s charter, Section 5 of which prohibits a forced transfer of property from one private party to another private party without consent. Additionally, California law requires an eminent-domain proceeding to be commenced in the county where the property being seized is located, and though the properties securing the notes at issue are located in San Bernardino County, many of the notes themselves are located outside the state, held by document custodians for the securitization trusts.
Finally, the memo discusses the considerable costs associated with the plan. The transaction costs would include litigating the propriety of exercising eminent domain in these circumstances, a prerequisite to using California’s “quick take” eminent domain procedure, on which MRP’s plan relies. Moreover, if MRP is wrong about the calculation of “just compensation” and the municipalities are required to pay more to the securitization trusts than MRP pledges, it could create substantial liabilities for the JPA and its members.
Implication: As the San Bernardino JPA considers MRP’s plan, it should be aware of the potential legal challenges to the plan and the potential cost to the municipalities and taxpayers associated with this novel and untested use of eminent domain. So too should other municipalities considering similar plans, such as Chicago and reportedly Sacramento, Elk Grove, and Berkeley, California, and Suffolk County, New York. The issues discussed in O’Melveny’s memo are also likely to be addressed during the comment period called for by the FHFA regarding the use of eminent domain to restructure performing home loans. If MRP’s plan is adopted, these issues will be at the forefront of resulting litigation for years to come.
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