Use of Eminent Domain to Restructure Underwater Loans

By   /   April 15, 2013 

 

Use of Eminent Domain to Restructure Underwater Loans

Kevin Etzel

I.               Introduction

The Inland Empire, a region of California consisting of San Bernardino and Riverside Counties, is just one of the many areas throughout the United States whose economy has deteriorated since the housing crisis began in 2007.1  As of May 2012, the unemployment rate throughout the region was nearly 12% — roughly 1.5 times higher than the national average.2  In need of a solution to this ever-growing problem, San Bernardino County has proposed to partner with its neighboring cities of Ontario and Fontana to create the Homeowner Protection Program Joint Power Authority (“JPA”).3  The organization plans to reach its ultimate goal of enhancing the “economic vitality and health” of the area by targeting the housing market.4  More specifically, it aims to reduce the effects of underwater loans and foreclosures on the community.5

 

II.             The Proposal

The JPA has recently considered a July 2012 proposal that would enable the County to utilize eminent domain to acquire underwater mortgages from mortgagees in order to restructure their loans.6  Mortgages are considered to be “underwater” when the home loan’s remaining balance is higher than the market-value of the property.7  The Inland Empire is inundated with struggling property owners, as 60.3% of single-family, owner-occupied homes are classified as underwater.8  The cause of underwater mortgages may be of no fault of the owner, but rather a result of falling home values in the region.9

Mortgage Resolution Partners (“MRP”) is a private entity that has proposed to partner with the JPA in order to “facilitate the eminent domain and mortgage restructuring process.”10  The government will force those with underwater properties to surrender their mortgages, but maintain possession of the real property.11  The mortgages would be restructured by setting loan amounts lower, so home-owners will reduce their negative equity, as well as their monthly payments.12  MRP, in its proposal, has expressly stated that taxpayer’s funds would not be used to support the program.13  It further stated that this strategy has been generated in order to avoid the high probability that underwater loans will default, further depreciating the value of the affected communities – an assumption that some critics believe is inaccurate.14

 

III.           Reactions to the Use of Eminent Domain

The MRP proposal will implement a method for restructuring performing loans that has become the subject of much criticism on not only legal and constitutional grounds, but also to how it will affect investors in the housing markets.15  Some of the more influential critics of the proposal have been the Securities Industry and Financial Markets Association (“SIFMA”), the Federal Housing Finance Agency (“FHFA”), and most recently, Congress.16

A.    SIFMA

SIFMA has vehemently opposed the financial strategy and has been one of the more outspoken critics of using eminent domain to restructure underwater mortgages.17  The trade organization, among other things, has raised constitutional and legal challenges to MRP’s strategy.  Pursuant to SIFMA’s request, Walter Dellinger, who has previously held positions as Assistant Attorney General, head of Office of Legal Counsel, and United States Solicitor General, issued a memorandum evaluating the legality of the current eminent domain proposal.18

First, Dellinger has stated that the transfer of these loans would not satisfy the “public use” requirement for the use of eminent domain.19  The “public use” element embodies the notion that a “ ‘sovereign my 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.’ ”20  The Supreme Court, in Kelo v. City of New London,21 warned of “one-to-one transfer[s] of property” that are not part of an “integrated” development plan, as they may be indicative of a “private purpose.”22  The type of plan contemplated in Kelo is not the same strategy proposed by MRP, in that comprehensive programs avoid the conferrence of “benefits on particular, favored private entities . . . with only incidental or pretextual public benefits.”23  According to Dellinger, the loans that MRP has targeted are not those that are imminently in danger of default, but rather those loans that are “performing.”24  Quite simply, unlike the comprehensive plan in Kelo, this strategy will confer a benefit on private entities, such as MRP and homeowners with performing mortgages.25  Allegedly, MRP, in managing the program, will receive a monetary benefit of $4,500 for every loan that it restructures.26

Second, the use of eminent domain requires that the government pay “just compensation” for the seizure of performing loans.27  Dellinger points out that the proposal accounts for the fair market value of the performing mortgages to be less than the face value of the loans – roughly 75-80% of the property’s market value.28  Upon evaluation, the court would likely find that the fair market value should be the value of the loan and not the value of the property.29  The notes are assembled into “securitization trusts that hedge the risk associated with nonpayment or prepayment of any single loan.”30  The value of each note within these trusts is the fair market value, so if MRP uses the value of the property, it is not properly providing “just compensation.”31  Also, Dellinger asserts that because these valuable notes will be removed from the trusts, it constitutes a “partial taking” that will ultimately damage the remainder of the trust.32  In effect, by removing these performing loans from the securitized pool, the trusts will be damaged by losing notes that will probably not default – a loss that must be factored in when assessing “just compensation.”33

In addition to possible violations of the Contracts Clause and Dormant Commerce Clause, Dellinger stated that because MRP’s proposal utilizes a “quick-take” eminent domain procedure, taxpayers and municipalities are susceptible to substantial financial risk.34  This type of eminent domain allows the government to take possession of the notes before the courts have properly determined the amount of just compensation to be paid.35  Therefore, if MRP did not evaluate the value of the notes accurately, the trusts will be damaged by removing performing loans from the securitized pool.36  Given the amount of loans to be restructured, MRP, as well as the municipalities, will be held jointly and severally liable for these substantial damages.37

SIFMA, as well as other interested organizations, have continuously made their presence known at JPA meetings, in order to aid the entity in developing a program that would benefit the most residents, with the least adverse effects.38  The JPA has assured residents and interested parties that it has not chosen MRP’s proposal and will continue to accept formal proposals.39

B.    Federal Housing Finance Agency

Given the national economic climate, the FHFA is apprehensive of the current proposal and issued a statement in the Federal Register expressing its concern for the financial strategy.40  FHFA is an entity that was created by the Housing and Economic Recovery Act of 2008 and has been given the authority to oversee the secondary mortgage markets.41  The entity supervises government-sponsored enterprises (“GSEs”) such as Fannie Mae, Freddie Mac, and Federal Home Loan Banks, which currently have debts and obligations of approximately 6.7 trillion dollars.42  In an already-depressed market, FHFA cannot allow increased losses attributed to the Inland Empire’s financial strategy, should the proposal go forward.  Although MRP has assured us that taxpayer dollars would not be used to fund its plan, FHFA has noted that if any of its GSEs experience losses as a result of the proposal, the taxpayers will inevitably bear the costs.43

Lastly, it could have a significant effect on the investors supporting the housing market— a concern that has also been shared and expressed by SIFMA, discussed infra.44  On August 9, 2012, the FHFA began accepting commentary from interested parties that would be helpful in determining what actions should be taken with regard to MRP’s proposal.45  On September 7, 2012, twenty-five local and national interested organizations submitted a joint response to FHFA’s notice.46  The letter provides a comprehensive overview of numerous objections to the MRP proposal, including legal and constitutional challenges, the impact the plan will have on mortgage markets and investors, as well the unfair allocation of profits and losses that will result.47

C.    Congress

As of September 13, 2012, Congress has been the latest entity to take a position on the Inland Empire’s consideration of the eminent domain proposal.48  California’s Republican Representative, John Campbell, introduced H.R. 6397, which would prohibit GSEs, the FHFA, and the Veterans Administration (“VA”) from purchasing and/or insuring mortgages that are backed by residences located in counties where the State has utilized eminent domain to seize mortgages.49  The bill has already gained support from several interested organizations, such as SIFMA and the Mortgage Bankers Association (“MBA”).50  Representative Campbell acknowledged that the housing market is in desperate need of assistance; however, he described the current eminent domain proposal as “atrocious, corruptive, irresponsible and unconstitutional,” and the means by which the housing market is aided should not “enrich undeserving, politically-connected entities in cities and counties with unsustainable budget deficits.”51

As an alternative, Campbell has co-sponsored H.R. 5940, also known as the “Preserving American Homeownership Act,” which would establish a program to reduce the principal amounts of loans associated with Fannie Mae and Freddie Mac.52  Although these bills are in their initial stages, their status will have a tremendous effect on how the JPA and other municipalities will manage the depressed housing market.

 

IV.           Conclusion

Although MRP’s proposal has been JPA’s main focus so far, JPA has recommended that it authorize its staff to develop a Home Ownership Protection and Foreclosure Prevention Program Request for Proposals in order to field other solutions to this problem.  Municipalities such as Chicago have also considered the use of eminent domain to restructure underwater mortgages, but Mayor Rahm Emanuel has made it clear, “[he doesn’t] think it’s the right way to address the problem.”53  More importantly, he noted that the housing issue is not just a local issue, but a national one, and should be dealt with on that level.54

Given its power, the use of eminent domain should be used only when completely appropriate, in order to avoid the proverbial “slippery slope.”  If all of the possible effects are not contemplated by these entities, extending the power of eminent domain to solve this issue may have grave implications on the market, as well as taxpayers.  Tim Cameron, SIFMA’s managing director of the Asset Management Group, expressed this view in JPA’s August 16, 2012 meeting, where he stated “the long-term costs and liability risks of an eminent domain proposal far outweigh any professed short-term benefits to a small group of performing owners.”55  Certainly, JPA will be the subject of public scrutiny as it tries to restore its communities and stabilize its housing markets.  The manner in which it does so will undoubtedly have an effect on other interested parties and, depending on its success, may be the model for other similar cities to follow – or avoid.

 

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Footnotes:

  1. Item to the Homeownership Protection Program Joint Powers Authority, Homeownership Protection Program Joint Powers Authority 1 (August 16, 2012), available at http://www.housingwire.com/sites/default/files/editorial/154059508152012091451427.PDF [hereinafter Item to JPA].
  2. Id.
  3. JPA Home, Homeownership Protection Program Joint Powers Authority, http://www.homeownershipjpa.org/Home.aspx (last visited Aug. 15, 2012).
  4. Item to JPA, supra note 1, at 2.
  5. Id.
  6. Homeownership Protection Program: A Solution to a Critical Problem, Mortgage Resolution Partners 11, available at http://online.wsj.com/public/resources/documents/EMINENT-powerpoint.pdf (last visited Aug. 13, 2012) [hereinafter MRP Proposal]
  7. Definition of Underwater Mortgage, Investopedia, http://www.investopedia.com/terms/u/underwater-mortgage.asp (last visited Aug. 15, 2012).
  8. Item to JPA, supra note 1, at 1.
  9. Kathryn Hatter, How to Define “Underwater Mortgage,” SFGATE, http://homeguides.sfgate.com/define-underwater-mortgage-9500.html (last visited Aug. 15, 2012).
  10. MRP Proposal, supra note 6, at 9.
  11. Thomas P. Vartarian, California County Considers Using Eminent Domain to Seize Underwater Mortgages, Dechert LLP 1 (July 2012), available at http://www.jdsupra.com/legalnews/jdsupra-25033/.
  12. Id.
  13. MRP Proposal, supra note 6, at 4.
  14. Id. at 5.  But See Memorandum from William Dellinger to Securities Industry and Financial Market Association 2 (July 16, 2012) (stating that “loans still performing after many months generally do not default.”).
  15. See Memorandum from William Dellinger, supra note 14 (analyzing whether the eminent domain proposal could withstand legal and constitutional challenges based on current legal precedent).
  16. See Use of Eminent Domain to Restructure Performing Loans, 77 Fed. Reg. 154 (Aug. 9, 2012); SIFMA Shares FHFA Concerns with Use of Eminent Domain to Restructure Mortgages, Securities Industry and Financial Markets Association (Aug.. 8, 2012), http://www.sifma.org/news/news.aspx?id=8589939853; Jann Swanson, Congress Gets Bill Prohibiting Eminent Domain Mortgage Seizures, Mortgage News Daily (Sep. 13, 2012, 3:43 PM), http://www.mortgagenewsdaily.com/09132012_eminent_domain_loan_mods.asp.
  17. SIFMA, supra note 16.
  18. Memorandum from William Dellinger, supra note 14.
  19. Id. at 3; U.S. Const. amend. V.
  20. Memorandum from William Dellinger, supra note 14, at 3 (citing Kelo v. New City of London, 545 U.S. 469, 477 (2005)).
  21. 545 U.S. 469 (2005).
  22. Kelo, 545 U.S. at 487.
  23. Memorandum from William Dellinger, supra note 14, at 4 (citing Kelo, 545 U.S. at 490).
  24. Memorandum from William Dellinger, supra note 14, at 4.
  25. Id. at 4-5.
  26. Mary Ellen Podmolik & John Byrne, Emanuel: Eminent domain not ‘the right instrument’ to address underwater mortgages, Chicago Tribune (August 14, 2012), http://articles.chicagotribune.com/2012-08-14/business/chi-emanuel-eminent-domain-not-the-right-instrument-to-address-underwater-mortgages-20120814_1_eminent-domain-underwater-homeowners-mortgages.
  27. Memorandum from William Dellinger, supra note 14, at 6; see U.S. Const. amend. V.
  28. Memorandum from William Dellinger, supra note 14, at 6.
  29. Id.
  30. Id. at 7.
  31. Id.
  32. Id. at 7-8.
  33. Memorandum from William Dellinger, supra note 14, at 7-8.
  34. Id. at 15-16 n.11.
  35. Id.at 15 n. 11.
  36. Id.at 15.
  37. Id.
  38. Statement, Tim Cameron, Esq., SIFMA Statement to Joint Powers Authority on Eminent Domain Proposal (Aug. 16, 2012), http://www.sifma.org/news/news.aspx?id=8589939947.
  39. Andrew Edwards, San Bernardino County foreclosure prevention agency to seek proposals, Daily Bulletin (Aug. 16, 2012 11:44:52AM), http://www.dailybulletin.com/ci_21328501/san-bernardino-county-foreclosure-prevention-agency-officially-accept?IADID=Search-www.dailybulletin.com-www.dailybulletin.com.
  40. Use of Eminent Domain to Restructure Performing Loan s, supra note 16.
  41. About FHFA, Federal Housing Finance Agency, http://www.fhfa.gov/Default.aspx?Page=4 (last visited Aug 16, 2012).
  42. Id.
  43. Use of Eminent Domain to Restructure Performing Loan s, supra note 16.
  44. Id.
  45. Id.
  46. Letter from SIFA, et al, to Alfred Pollack, General Counsel to Federal Housing Finance Agency (Sep. 7, 2012), available at http://www.sifma.org/workarea/downloadasset.aspx?id=8589940214.
  47. Id.
  48. Swanson, supra note 16.
  49. Id.
  50. Id.
  51. Id.
  52. Id.
  53. Podmolik & Byrne, supra note 26.
  54. Id.
  55. Tim Cameron, supra note 38.