Is Richmond's Mortgage Seizure Scheme Even Legal?
On September 21, The Washington Post published a blog titled Is Richmond’s Mortgage Seizure Scheme Even Legal?
Is Richmond’s mortgage seizure scheme even legal?
The possibility of using eminent domain to reduce underwater mortgage debt in the city of Richmond California survived several tough challenges a week ago. As Lydia DePillis reported, the City Council decided to go ahead with the process after a long hearing that could have possibly derailed it. Meanwhile an attempt by Wells Fargo and Deutsche Bank to have the action shut down even before it properly started was tossed out by a U.S. District Court (Judge: “Isn't this, as we say in the trade, a no-brainer?").
The arguments will now proceed to the two parts of eminent domain law: demonstrating public purpose for the takings and offering fair-value. Since this is the furthest an eminent domain case has made it, it might be useful to step back and walk through the arguments. If the case succeeds, it is likely other cities, which have been hesitant, will consider going forward.
What is going on in Richmond?
Richmond, California is one of the hardest hit cities in the housing collapse. The median sale price of housing fell from about $450,000 in January 2006 to $220,000 today. Roughly 51 percent of mortgages are underwater, and the average underwater homeowner owes 45 percent more than their home is worth. 16 percent of homeowners with a mortgage have suffered a foreclosure.
Richmond has proceeded by offering to purchase 624 mortgages held in private-label securities, offering a price as determined by an independent appraisal. The offer explained that they would attempt to negotiate first, but if they failed they would use their eminent domain powers.
However, in a technique argued since the beginning of the crisis by Cornell law professor Robert Hockett, rather than use eminent domain on the house itself, the city would seize the mortgage. A private investment company, Mortgage Resolution Partners (MRP), would in turn write down the mortgage amount to something closer to the current value. They would collect a profit and refinance the loan. The homeowner would be less likely to default with a lower loan amount, or would be able to sell without a short-sale, leaving him or her with more money to spend locally.
So wait, the city wants to use eminent domain on mortgages? I thought you could only use eminent domain on, like, actual property and things.
Interestingly enough, that is not the case. The issue here is whether or not a property that is “intangible” can be taken under eminent domain. And it can.
The very first time the Supreme Court heard a case on eminent domain, in fact, had to do with a state taking an intangible form of property. In the 1848 case West River Bridge Company v. Dix, the state of Vermont used its eminent domain powers to take a franchise contract. The Court argued that the distinction between “property which is corporeal” or tangible and property that is intangible, like the franchise under question, “has no foundation in reason.” They were “aware of nothing peculiar to a franchise which can class it higher, or render it more sacred, than other property.”
Since then, eminent domain cases have come up in everything from sports franchises to stocks, and every time the fact that the property in question wasn’t a physical thing didn’t matter for the case.
So what problems do the banks have with it?
Here’s where it gets interesting. The banks are arguing that it is in fact against the Constitution to use eminent domain on these mortgages in question, as well as that it doesn’t serve the public purpose and there is no fair-value offer that would make the plan workable.
Wait, so it is illegal to use eminent domain on mortgages?
The banks are arguing that there’s something specific to the nature of securitized mortgages that have been financially engineered into bonds and eminent domain that goes beyond previous cases.
Their first, and main, argument, is that the mortgages don’t actually exist in Richmond. And since Richmond can only use eminent domain for these within its territory, if the mortgages aren’t there it is a problem. The banks argue that the mortgages, because of their slice-and-diced nature, exist legally somewhere other than Richmond. (Given the notorious document fraud in the financial industry when it comes to these mortgage bonds, it’s likely the financial industry also doesn’t know where the mortgages are, but that’s another issue.)
The courts use a variety of tests to figure out where intangible property resides, and it can in turn reside in several different places for different legal purposes. Richmond argues that when considering where an intangible property resides, the mortgages are incurred by Richmond residents and secured by property in Richmond, and there’s extensive case law that this is the important distinction that should be used for eminent domain purposes.
The banks are also arguing that this is a state trying to set interstate commerce for the nationwide housing market, and is thus illegal under a “dormant commerce clause.” The banks also argue that it would violate the Contracts Clause of the Constitution, because the debts of local citizens would be forgiven at the expense of creditors.
However, the Supreme Court has consistently argued that eminent domain supersedes the Contracts Clause. And there’s nothing in this process that would discriminate against out-of-state creditors versus in-state. (Indeed, the creditors who would face writedowns could be in the same state.)
One never knows what courts will do, but in general the argument that this is illegal because of something to do with the mortgages themselves doesn’t seem that strong. Hence the real fighting over public purpose and valuation.
So that leaves public purpose and costs. What is the public purpose of this program?
This is what will be argued next in Richmond. It is very likely Richmond will argue that preventing blight is a major, legitimate public purpose, and the courts agree. Abandoned homes result in increased crime and significant public costs, in addition to destabilizing neighborhoods. According to the Richmond city manager, William Lindsay, the city had to haul 295 tons of trash off of private property, most of it from vacant homes in 2010 alone. And that says nothing of the police and fire services that have had to dedicate resources away from regular crimes to deal with vacant homes.
The banks argue that the loans are performing (more on their argument about this in a minute), and as such don’t serve a public purpose. But there’s also a public purpose in solving problems in the coordination of mortgage servicers to writedown and deal with failing mortgages. There’s also the public purpose of allowing people to move as well as refinance allowing for the movement of individuals as well as the ability to refinance. These are all legitimate purposes of eminent domain; indeed one such Supreme Court case from the 1980s found that “reduc[ing] the concentration of land ownership” is a legitimate public purpose for eminent domain.
What’s this about coordination?
There’s been a lot of development in the argument that the middlemen in mortgage servicing have both significant conflicts of interest as well as are underinvested to handle these issues. As Adam Levitin and Tara Twomey argue, servicers “do not have a meaningful stake in the loan‘s performance,” and their business structure “encourage servicers to underinvest in default management capabilities, leaving them with limited ability to mitigate losses.”
Their incentives don’t match those of the investors they are supposed to work for. They are make more money dragging out mortgage issues, while padding their costs along the way. And they are “incentivized to favor modifications that reduce interest rates rather than reduce principal, even if that raises the likelihood of redefault.”
One function of regulation is to coordinate the actions of many different parties into productive paths -- think of traffic laws. Coordinating creditors and investors is usually the function of the bankruptcy code, but bankruptcy isn’t applicable for home mortgages. However eminent domain is often used for this purpose of coordinating and forcing a sale, and it can do the same here in breaking coordination problems among the many different, broken parts of the mortgage chain.
Ok, so the real fight is probably about valuation. Is this a highway robbery issue?
As a reminder of process, the courts will have to agree that any price paid is an actual fair-value price. "It is a legal requirement that fair value is paid," Robert Hockett told me. "The courts are going to do their duties, and hear arguments under an adversarial system. This isn't a new issue. Across a range of legal issues, including eminent domain, the courts have to figure out the legal value of something. Both sides will offer valuations, and bring experts to explain different methodologies under cross-examination. The court itself may impanel their own witness. And they'll ultimately decide what fair value is."
The banks argue that the only way to make this work is to pay far below what would have been given in a fair negotiation. Richmond, in turn, argues that their offers were generated by appraisers that the financial industry itself uses. Indeed, Richmond doesn’t “make offers” -- it instead hires independent appraisers who come up with the valuations that were proposed.
Now the fight will continue to what methods those appraisers use, and that is likely where the court fight will settle. One way to evaluate these mortgages would be to compare them to bonds of mortgages containing similar instruments and see what discount is used. Given the still high levels of foreclosures, this would generate a significant discount. This is a common technique to evaluate risk and valuations when markets aren’t available, say for understanding the credit risk of a brand new company, as they aren’t in high foreclosure areas.
The banks also argue that the fact that a majority of homeowners are current on their loans means that they aren’t relevant to either public purpose or subject to a steep discount. But, in a high-risk zone with unemployment still high, current mortgages can easily fall apart. There’s also an argument that if you only picked mortgages that were failing, you’d encourage a kind of moral hazard that could amplify the very problem the city is trying to stop. Regardless, the valuation in eminent domain is a matter for the courts to ultimately decide, hearing from independent appraisers and experts.
Will this collapse the Richmond housing market?
The biggest remaining worry is whether or not this will permanently harm the ability of people in Richmond to get new mortgages. One of the main arguments from the banks is that the housing market is recovering at a rapid clip, and if this process scares off lenders then it could both hurt all future homeowners and the fragile recovery.
It’s early to tell whether or not this would be an issue, and if so how big it would be. As Peter Dreier, a professor at Occidental College and an expert on housing policy, argued in the Richmond case, stabilizing the mortgage market is far more important in making credit widely accessible. Banks always, as a rule, threaten on this front on all consumer related issues, yet with a stable mortgage market Richmond would make a reasonable investment opportunity.
At the end of the day, isn’t eminent domain shady?
Eminent domain gets a well-deserved negative rap for its role in so-called urban renewal projects, and many other instances of the state taking from the poor or even average citizens to give to the rich and developers. Just listen to Fugazi.
However, there’s an important role for eminent domain in forcing coordination among many different agents who, for a variety of institutional and legal reasons, find it hard to coordinate among themselves. The story about how mortgage originators abused their responsibility in originating mortgages, at the expense of both investors and borrowers, is well-understood. But what is equally well-documented but less understood is that what is going on in the foreclosure process is the mirror image of that same thing. Fundamentally, these problems are the type eminent domain can solve.
Meanwhile, some seven years since the housing market collapsed, the country is still fundamentally dealing with the same issues. The federal government and the administration had multiple attempts to address these issues since the beginning of the bailouts, and they have either failed or ignored them. It is entirely appropriate that local government take the steps they need to in order to address their housing market if they can make the case to their constituents and to the courts that the situation is this desperate. Because for many people, including the residents of Richmond, California, it is.
To view the online article, please click here.