Plan to Seize Underwater Mortgages Not Viable

Sound too good to be true? Is the plan really viable? Yes to the first, and no to the second.

Eminent domain - enshrined in the Fifth Amendment - is the power of a public entity to take private property for a public project, so long as the public entity pays fair market value for the property it takes. While the process is usually used for roads and schools and public buildings, the Supreme Court has allowed the power to be exercised whenever a public purpose can be shown.

Much of the debate around the idea of acquiring underwater mortgages by eminent domain has centered on whether a public entity has the constitutional right to do so. But let's assume that it can. How does the plan fit within existing laws governing eminent domain proceedings?

Here is where the advocates of the plan have shown an acute lack of knowledge and understanding. In its PowerPoint presentation to the city of Richmond (available on the city's website), MRP repeatedly referred to an eminent domain "motion" - thereby downplaying the entire procedure. Eminent domain proceedings involve a full-fledged lawsuit filed against the owner of the property by the public entity. A summons is issued, pleadings are filed, court appearances are required, and the entire California eminent domain law is invoked. Appraisers are retained by both sides to value the property. The case cannot go to trial any earlier than one year after it is filed. Calling it merely an eminent domain "motion" utterly disregards the procedure that must be followed.

For example, MRP's presentation to the city said that, after the city files its eminent domain motion, a homeowner can simply choose to opt-out and will be dropped from the motion. This overlooks the legal requirement that the city would have to pay the lender's attorney fees if the city abandoned an eminent domain lawsuit after filing it.

And then there's the critical issue of valuation. The government must pay fair market value when it acquires property by eminent domain. California law defines "fair market value" as the highest price that would be agreed to between hypothetical fully informed buyers and sellers, under no pressure to buy or to sell. And it is the highest price that would be paid for the particular loan being acquired, not for the bulk purchase of hundreds of pre-packaged loans.

So exactly which loans are going to be selected for acquisition? That's the job of MRP, which touts on its website various writings by Professor Robert Hockett of Cornell Law School, a staunch advocate of the plan. In his 2012 research paper "It Takes a Village: Municipal Condemnation Proceedings and Public/Private Partnerships for Mortgage Loan Modification, Valued Preservation, and Economic Recovery," Professor Hockett gives some insight into which loans will be acquired. The first selected mortgages, he says, "must be current on their obligations - hence good credit risks - and owe on significantly underwater mortgage obligations."

Whoa there. So the mortgages targeted for acquisition are to be "current." What's the highest price somebody would pay for a performing $300,000 income stream paying 6 percent - the example used by MRP in its presentation to the city of Richmond? According to MRP, the lender that is owed $300,000 on a performing loan paying 6 percent interest will simply agree to have it acquired for $160,000. The entire plan is based on that agreement. And, according to MRP, the total legal costs involved to get there will be $1,950. That's less than Earl Scheib used to charge to paint a car.

To be blunt, this is hallucinatory. Lenders won't roll over and simply sell their performing above-market loans at a 47 percent discount. These actions will be contested. And contested eminent domain proceedings can cost hundreds of thousands of dollars - maybe even more than the balance of the loan.

MRP has overlooked the many reasons why people continue to pay on underwater loans. First, they need a place to live, and they will have housing costs to pay even if they default and walk-away from their underwater mortgages (with credit problems to boot). Second, borrowers optimistically hope that the value of their homes will rebound and they will no longer be "underwater," optimism perhaps supported by the strong recent rebound in housing prices. Third, there are certain people who - crazy as it may sound to Wall Street - feel that they should meet the obligations they chose to undertake. All of these factors must be taken into account in determining the highest price that a buyer would pay for a loan on which the borrower is currently paying.

The city of Richmond (like all public entities) ought to realize that the fair market value of property acquired by eminent domain is determined by a jury, and juries frequently award far more compensation than the public entity thinks is the right amount. In 2006, the local park district acquired a parcel of property in Richmond by eminent domain. The public entity thought it was worth $892,000. The jury returned a verdict of $6,845,000.

Similar stories abound throughout the state. Just last year, I tried an eminent domain case in Riverside County. The government told the jury the property it was taking was worth only $2.3 million. Yet the jury's verdict was for $15 million.

The MRP plan is based on an economic analysis that is highly unrealistic, and all the balls must bounce in its favors for the plan to work. Lenders will not agree to massive write-downs of their performing loans without a fight. And somebody is going to pay a lot more than $1,950 for attorneys to represent the city in the valuation contests.

The city of Richmond would do well to follow the example of the Joint Powers Authority set up in the Inland Empire, which earlier this year after much study declined to proceed with the plan to seize underwater mortgages by eminent domain. Otherwise, the city may end joining other cities like Vallejo, Stockton, San Bernardino, and Detroit in a very different courtroom.

 

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