Richmond’s Mortgage Heist

Tuesday, August 13, 2013

Right now, Wells Fargo Bank is on a collision course with the City of Richmond, California. Wells Fargo objects to the city’s plan to use its eminent domain power to condemn private mortgages secured by Richmond homes. The proposed program does not target the homes themselves, but only mortgages that are now held by a large number of residential mortgage-backed securitization (“RMBS”) trusts, for which Wells Fargo serves as trustee. Most of the targeted mortgages are “performing assets.” The borrowers are current on their payments, even for mortgages that are technically “underwater” so that the market value of the property is below the amount owed on the mortgage debt.

Illustration by Barbara Kelley

Wells Fargo filed a major lawsuit last week against Richmond in federal court in the San Francisco Bay Area, challenging the program as a get-rich-quick scheme at the expense of mortgage lenders throughout the United States.

Mayor Gayle McLaughlin, a member of the Green Party, stoutly defends the program in part as payback against those that “sold our community predatory loans,” which have led to threats of foreclosure. So, she warns, if the banks do not agree to voluntary sales of these loans to the city for what she terms fair market value, Richmond’s private partner, Mortgage Resolution Partners (MRP), will defend the litigation in order to execute the plan.

A recent Washington Post story reports that Cornell Law School Professor Robert Hockett, who dreamed up this scheme, denounced the lawsuit as “essentially another stage in their strategy to scare cities.” But that same story reports that the Federal Housing Financial Agency may direct Fannie Mae, Freddie Mac, and the Federal Home Loan Banks “to limit, restrict or cease business activities within the jurisdiction of any state or local authority employing eminent domain to restructure mortgage loan contracts.” Obviously others are scared as well.          

The Richmond/MRP Plan

In seeking to wrest control of these mortgages, Richmond can resort either to voluntary or coercive tactics. No one objects to the former. If the two sides can agree on a sales price, let them do it, as both sides will be better off. But now that the lenders have flatly said no, how can the city show that its offer is fair? Indeed, the gist of the bank’s complaint is that the city can make money out of this costly transaction by taking the RMBS trusts to the cleaners. The ominous financial implications of the proposed strategy are explained in stark terms in the complaint:

In an example provided by MRP, an underwater loan on a home worth $200,000 would be seized by eminent domain for $160,000 (or 80% of the home’s value), and then refinanced into a new FHA loan for $190,000 (or 95% of the home’s value). The $30,000 spread between the seizure price and the refinancing price would be divided (after expenses) among Richmond, MRP, and MRP’s investors.

The obvious objection to this scheme is that it rips off the mortgage pools by the ambiguity of the phrase fair market value. But in many ways, the last thing that Well Fargo wants to do is to get tied up in a lengthy battle that casts a pall over all these trust assets. Hence the bank raises three other objections to the program that might result in its immediate invalidation: jurisdiction, dormant commerce clause, and public use, which must be considered before reaching the just compensation issue.

The Legal Issues

Jurisdiction The first objection to be considered is whether the City of Richmond has any power to condemn these mortgages at all. The complaint denies that they are located in Richmond. It asserts that the city seeks “to impermissibly use Richmond’s power of eminent domain to seize certain mortgage loans located outside of Richmond in order to generate profits for Richmond, MRP, and MRP’s private investors.” Ordinarily, a government can only exercise its power of eminent domain over property that is located within its territory. Otherwise, every city and county in the land could condemn every piece of property located in California. At the same time, now that these mortgages have been sliced up into small tranches, it is hard to find any other single place that could count as their home other than Richmond.

Suppose that Richmond chose to condemn one of these mortgaged residences for use as a city park. The condemnation wipes out both the occupant and the mortgage holder. But there seems nothing untoward about this process, so long as the proceeds from condemnation are used to pay off the loan before the excess is remitted to the mortgage debtor. So, probably, the mortgage is located there after all. Richmond may be able to take the mortgage, but no other city in the land could.

Dormant Commerce Clause – There are, however, two further obstacles to City’s grand program. The first of these involves what is commonly called the Dormant Commerce Clause argument, which asks whether the activities of Richmond so disrupt activities or transactions in interstate commerce that they should not be allowed to go forward.

Dealing with Dormant Commerce Clause questions always involves a balancing test that asks about the relative strength of the local and national interests. By that standard, it seems pretty clear that Richmond comes off second best. First, these condemnations impose extensive burdens on the ability to form and market these syndicates in national markets. It is one thing for loan pools take the risk of foreclosure; that’s part of the business they are in.

But the politicized condemnation of select mortgages out of these pools raises very different issues. If Richmond can impose the scheme, so too can every other city. The cumulative impact of these plans would disrupt trading in the interstate market. And if, as will become clear, the benefits offered by Richmond are all low-ball estimates, the cumulative impact on these mortgage pools could be catastrophic. At the same time, Richmond could use local mortgage supplements generated from tax revenues to ease the local foreclosure risk. On balance, the interstate dislocation swamps the local inconveniences, which means that the District Court will likely strike down the plan globally and not on a costly case-by-case basis.

Public Use – The third objection to this program is that Richmond is not taking the mortgage loans for a constitutionally permissible “public use.” After the disastrous 2005 decision of the United States Supreme Court in Kelo v. City of New London, property can now be taken for any “conceivable” public use, including private development of real estate once owned by others.

The Kelo decision serves no precedent for the current case. In Kelo, the local government could at least make the feeble argument that it needed to assemble multiple plots of land in order to develop a new hotel complex to service the Pfizer plant that was at the time located nearby.

But the Richmond mortgage scheme does not purport to assemble land for any project, but only to acquire mortgages by force that it could simply acquire individually in separate voluntary transactions. There is no risk of a bank hold-up that can only be overcome by government coercion. And any form of “blight control” should be directed against the party in occupation, not against lenders.

Just Compensation – Even if these objections are for some reason rejected, the Richmond/MRP program necessarily founders on the question of whether the condemnation meets the just compensation requirement of the Fifth Amendment. The standard in this case is that the payment must be “a full and perfect equivalent of the property taken.” In many cases, that question raises thorny issues because there is no ready market for power-line easement over private property. But these mortgages are financial instruments that can be freely traded. If the RMBS trusts don’t want to sell the interests for the sums offered, the fair value inquiry is at an end. The amounts offered are not sufficient to win over a willing buyer. If there is a $190,000 jackpot at the end of the rainbow, it belongs to the lenders, not to the City of Richmond.

Nor does it matter that the condemnations are directed only against underwater mortgages. Many targeted mortgages are still current because their subjective value in use to the owner exceeds the amount of the lien, even if the lien exceeds the market of the property. Even if the mortgage is about to go into default, the result does not change. Of course the mortgage lender will take a hit, but not to the extent that it would through one of these dubious condemnations.

Suppose the property subject to the $200,000 mortgage is only worth $100,000 in foreclosure. It doesn’t follow that Richmond can swoop in with a condemnation offer of $80,000, costing the lender $20,000. The only way it makes sense for Richmond to take over these mortgages is if the lender can extract some value from them that the banks cannot, and that is just not going to happen.

Richmond and MRP may make a short-term killing from this dubious scheme, but property owners, both in Richmond and elsewhere, are long term losers if it becomes impossible for homeowners in hard-pressed communities to borrow funds from banks that won’t lend when they know that these loans can be taken from them. The situation is doubly troublesome today now that housing prices are coming back making Richmond’s operating premise of widespread failure ever more questionable.

Housing markets need time to heal, which they won’t get if these ill-advised condemnation schemes live to see the light of day. Once again for government, doing nothing is often doing the best thing possible.