When activist governments team up with profit-hungry investors, someone is bound to get hurt. This summer, the City of Richmond, California and Mortgage Resolution Partners (MRP), a Silicon Valley-based venture capital firm, launched a creative scheme that relies on eminent domain to seize mortgage-backed securities held by mortgage trusts (think PIMCO and BlackRock) in order to forcibly reduce the principal on underwater homes in Richmond, California. According to the plan’s proponents, this scheme allows the government to reduce the principal on underwater mortgages, increasing the likelihood that an underwater homeowner will be able to keep his home and avoid foreclosure (while generating a tidy transaction fee for MRP).
This scheme – recently considered and rejected in San Bernardino, California and several other cities – is the topic of an article titled “Eminent Domain, Mortgage-Backed Securities, and the Limits of the Takings Clause” that I am publishing in the forthcoming issue of the Journal of Law and Liberty.
In my article I examine both the mechanics of this unprecedented plan and the difficulties the plan is likely to face under the Fifth Amendment’s Takings Clause, which dictates that “private property” cannot be seized by the government unless the property is taken for the “public use” and its owners are offered “just compensation.” While the article examines the plan as devised for earlier cities, the Richmond, California plan is largely based on these earlier plans.
The plan’s mechanics are relatively straightforward: the city government and MRP identify underwater homeowners and then seize the respective homes’ underlying mortgages via eminent domain. The plan exclusively targets mortgages that have been securitized and are held by securitization trusts, paying the trusts (at most) 85% of the market value of the underlying home. Once the city owns the mortgage, it reduces the money owed on the note to roughly the home’s current market value and the mortgage is resold to another group of investors at 95% of the home’s value. The plan looks clever from the perspective of the city and MRP. Cities can claim that they are reducing the likelihood that homeowners will default on their mortgages by reducing the principal owed by underwater homeowners. Because defaults lead to foreclosures, which can lead to a flood of unsold homes and declining real estate prices, the plan is purported to buoy home prices in regions most harmed by the housing crisis. From MRP’s perspective, the deal is a moneymaker, as MRP receives a $4,500 fee per transaction for its role in implementing the plan.
Unfortunately, as is the case with every big-government scheme, there is no free lunch, even if the party footing the bill is a faceless, unsympathetic investment fund or mortgage trust. The original mortgage holders lose both their collateral and the revenue stream of mortgage payments plus interest. In return, the trusts are paid less than the fair market value of their collateral, raising serious doubts as to whether “just compensation” is offered.
In my paper, I analyze both the “public use” and “just compensation” arguments against the plan’s constitutionality. While the Supreme Court has granted municipalities a wide berth for experimenting with eminent domain plans (see Kelo v. New London and Hawaii Housing Authority v. Midkiff, which equate the “public use” requirement with the rational basis test), the current plan’s public use goals are likely outweighed by the tangible and substantial harm that the plan inflicts on the mortgage trusts and their underlying investors. This harm could reverberate throughout the economy and will likely end up harming the very homeowners and borrowers the plan purports to aid, as lenders will increase mortgage rates in order to account for the risk that their performing mortgages can now be stripped from their balance sheets with little payment in exchange.
Under the Fifth Amendment’s “just compensation” requirements, the plan faces even tougher obstacles, as the plan overtly offers noteholders less than the value of their collateral. Proponents of the MRP plan claim that this price writedown represents the “foreclosure discount” that occurs whenever lenders attempt to quickly sell collateral after a default. However, this argument assumes that the loans in question are at imminent risk of default, when in reality, many of the loans seized under the MRP plan will be performing loans that present a relatively low risk of default.
Although a federal court in California recently declined to hear legal challenges to the Richmond MRP plan due to ripeness issues, once the plan is implemented, the plan will face a barrage of lawsuits that will explore the above issues and more. We will have to wait and see if courts are ready to rein in this creative expansion of the Takings Clause. In the meantime, you can read a thorough analysis of these issues in “Eminent Domain, Mortgage-Backed Securities, and the Limits of the Takings Clause.”
*Hampton Foushée is a J.D. Candidate at New York University School of Law, Class of 2014. The Journal of Law & Liberty published Mr. Foushée's student note entitled Eminent Domain, Mortgage Backed Securities, and the Limits of the Takings Clause in Volume 8.1 (now available online here). Mr. Fousheé will be a corporate associate at Sullivan & Cromwell LLP starting in the fall of 2014.