July 11, 2012 / 10:22 PM / 7 years ago

Eminent domain, MBS and the U.S. Constitution: a one-sided fight?

(Alison Frankel writes the On the Case blog for Thomson Reuters News & Insight newsandinsight.com. The views expressed are her own.)

By Alison Frankel

NEW YORK (Reuters) - If you’re already inclined to suspect governments of overreaching, boy will you hate the plan San Bernadino is contemplating.

About half of the homeowners in the newly bankrupt California city are underwater, which means they owe more on their mortgages than their homes are worth.

In conjunction with a San Francisco outfit called Mortgage Resolution Partners, San Bernadino is considering a plan to exercise eminent domain and seize mortgage liens on some of those underwater homes. As my Reuters colleagues Matt Goldstein and Jennifer Ablan were the first to report, the eminent domain scheme works like this: With financing from an outside operation such as MRP, the city would condemn underwater mortgages and purchase them in the name of the public good for a court-determined fair market price.

The financier would then make new mortgage loans to homeowners under modified terms before turning around and selling the modified loans to outside investors. As eminent domain proponents describe the plan, it’s a winner for everyone: Homeowners see their loan principal reduced and get to keep their houses, financiers turn a profit on the resold mortgages and the city avoids the blight of foreclosed homes, which drive down property values and destroy neighborhoods.

But there are also losers in the eminent domain model: investors in mortgage-backed securities. San Bernardino is talking about exercising eminent domain only over mortgage loans that have been bundled into private securitizations. Those mortgages are owned by MBS trusts, which, under eminent domain, would be forced to accept fair market value for underlying loans they don’t want to sell. To add insult to injury, the San Bernadino plan proposes that only performing loans be part of the initial wave of eminent domain seizures. That’s to reward homeowners who have managed to live up to their mortgage obligations. But from the perspective of MBS investors, seizing loans that are still being paid on time means they’re being stripped of an ongoing revenue stream.

You can see why MBS investors and other industry groups are up in arms about the eminent domain solution to the foreclosure crisis. To them, it’s tantamount to government-sanctioned theft. At the end of June, a coalition of 18 powerful players, including the American Bankers Association, the Securities Industry and Financial Markets Association and the Association of Mortgage Investors, sent a joint letter of protest to the San Bernadino Board of Supervisors. “We believe that the contemplated use of eminent domain raises very serious legal and constitutional issues,” the letter said. “It would also be immensely destructive to U.S. mortgage markets by undermining the sanctity of the contractual relationship between a borrower and creditor, and similarly undermining existing securitization transactions.”

The letter doesn’t actually go on to outline those “very serious” legal issues, so, at the suggestion of coalition member Chris Katopis of AMI, I reached out to Marko Mlikotin of the nonprofit California Alliance to Protect Property Rights. Mlikotin, whose group recently sponsored an unsuccessful ballot initiative to curb state and local government rights of eminent domain in California, spoke eloquently about what he considers a dangerous abuse of power in the mortgage seizure plan. “San Bernadino has embraced the view that the government’s power of eminent domain has no boundaries,” he said. If a city can condemn and seize mortgage loans in the name of the public good, Mlikotin said, what’s to stop it from exercising eminent domain over pension fund obligations to public employees? There’s certainly an argument to be made that a takeover of those obligations would benefit the broader public. According to Mlikotin, any intangible asset is up for government grabs if San Bernadino is allowed to seize securitized mortgage loans. As another critic of the eminent domain plan, law professor Anthony Sanders of George Mason University, told me in an email, “Eminent domain has been used to seize land for public improvements such as railways, highways and public building projects. It was never intended to seize securities and debts. If this is allowed, we have crossed the line.”

But here’s the thing: Courts have long since crossed that line, according to Cornell law professor Robert Hockett, who wrote a 55-page paper that provides the structural and legal underpinning of the San Bernadino plan. (Hockett also wrote a much shorter Reuters op-ed on the issue; he told me he was hired by Mortgage Resolution Partners to research the legality of exercising eminent domain over private mortgage loans but has not been paid by San Bernadino.) To begin with, Hockett pointed to the U.S. Supreme Court’s 2005 opinion in Kelo v. City of New London, which held that New London, Connecticut, had the right to seize property on behalf of a private developer because the developer’s urban renewal plan was in the public interest. The controversial Kelo ruling has been a scourge of private property rights activists, but it’s the foundation of San Bernadino’s eminent domain plan; according to Hockett, San Bernadino’s proposed exercise of eminent domain is much easier to justify as a public benefit than New London’s in the Kelo case.

Hockett also pointed to federal and California precedent for eminent domain seizure of intangible property, as long as the public benefits. “Under the federal rendition of this authority, for its part, the U.S. Supreme Court and the Courts of Appeals have regularly held that the authority extends, for example, to contract rights, insurance policies, shares of stock, businesses as going concerns, hunting rights, rights of way, and all manner of additional intangible (assets),” Hockett asserted (with citations). “U.S. states follow the same longstanding common law tradition as does federal law in this connection. California’s Supreme Court, for example, long has explicitly recognized that ‘(the state’s) eminent domain law authorizes the taking of intangible property.’” In one of the most notable California cases Hockett cited, a state appeals court said the Oakland Raiders football franchise was subject to an eminent domain seizure.

In an interview Wednesday, Hockett conceded that the eminent domain seizure of a mortgage loan has apparently not been tested explicitly in court. But he said that’s because before the unique circumstances of the housing bubble, governments never had reason to condemn mortgages for the public good. Courts have approved the seizure of plenty of other securities and liens, he said. “Eminent domain applies to any kind of property, period,” he said. (His paper, moreover, cites a 1993 Nebraska Supreme Court holding that “a mortgagee’s lien on real estate is an interest that may be subjected to a taking for a public purpose and, therefore, may be the subject of an eminent domain proceeding.”)

The only possible complication, according to Hockett, could be jurisdictional because the owners of the seized mortgages — i.e., the MBS investors — don’t necessarily reside in the same place as the mortgaged property. But that’s an arcane analysis very unlikely to sink the San Bernadino plan.

Hockett told me that the constitutional gauntlet thrown down by the industry groups opposed to the eminent domain plan seems to him to be a negotiating tactic in the eventual fight over the fair value of the seized mortgages. “The fact that those groups came out so early on told me they’re not really convinced (that there are legal problems with the plan) but are engaged in haggling,” he said. “This is a kind of kabuki-theater haggling over price.”

I found Hackett’s analysis very convincing, especially because he told me he spent five or six weeks researching the legality of eminent domain seizure of mortgage loans. But I’ll give the last word to an opponent of San Bernadino’s plan, who is just beginning his examination of its constitutionality: Anthony Caso of the Chapman University School of Law and the Center for Constitutional Jurisprudence, to whom California property rights activist Mlikotin sent me. Caso told me he believes there’s a key legal difference between mortgage loans and ordinary securities because mortgage notes include a continuing contractual obligation to pay off the loan. Under the U.S. Constitution’s Contracts Clause and California’s even more stringent state version of the contracts provision, governments may not interfere with private contracts except in extreme circumstances. Caso said there’s a good argument that San Bernadino’s plan to use eminent domain conflicts with the Contract Clause.

What about all of the precedent approving eminent domain seizures of other liens? I sent Caso Hockett’s paper, and he sent back an email: “None of the cases cited by Professor Hockett concern an attempt to condemn a mortgage interest,” he said. “That government is prevented from destroying the value held by the lien holder without paying damages does not permit the government to condemn the note and deed of trust simply so that it can turn a quick profit. ... Both the California and U.S. Constitutions forbid state and local entities from impairing the obligation of contracts — this restriction on power is separate from the obligation to pay just compensation when government destroys property.”

I have a feeling we haven’t heard the end of this debate. Stay tuned.

Reporting by Alison Frankel; Editing by Eddie Evans

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