Wall Street sues California city looking to bail out homeowners

A city in California has become ground zero in a battle with mortgage lenders and now the federal government in its push to implement a radical new plan to assist homeowners who cannot meet the terms of their loans.

The Bay Area city of Richmond is the first to push for the use of eminent domain in a plan that would see mortgages in repayment delinquency seized from lenders and investors, or rather sold at a deep discount, by the city, and then refinanced on behalf of borrowers with more affordable terms.

The US Federal Housing Finance Agency, which regulates mortgage giants Fannie Mae and Freddie Mac, has now said that it will move to halt the use of eminent domain by cities to seize underwater mortgages from lenders.

Richmond, a working-class city of 106,000 people in the East Bay, has a large population of both blacks and Latinos, and was hard hit by the US housing crisis, with homeownership rates considerably below the national average according to the LA Times.

Richmond’s plan is unusual since eminent domain is usually only invoked to obtain land needed for public projects such as highways, or at other times to take possession of run down and abandoned structures. The concept itself is deeply ingrained in both the US Constitution and that of state constitutions.

The federal housing agency indicated on Thursday that it has no intention of allowing the city to go forward with its mortgage plan, and will instruct Fannie and Freddie to "limit, restrict or cease business activities" in any jurisdiction using eminent domain to seize mortgages according to the Los Angeles Times.

The agency’s move on Thursday has now set the stage for a battle that has been developing since last week, when three mortgage-bound trustees filed a suit in a federal court in Northern California and asked for a preliminary injunction against the city of Richmond and Mortgage Resolution Partners, a firm contracting with the city to implement its planned strategy.

The mortgage holders involved in last week’s suit were prompted to sue by firms including Newport Beach-based Pacific Investment Management Co., BlackRock Inc. of New York and DoubleLine Capital of Los Angeles. According to the lawsuit, Richmond’s program could potentially cost investors losses of $200 or more.

Though the lawsuit involves large players in the mortgage securities business Mortgage Resolution Partners Chairman Steven Gluckstern seemed unphased, calling the suit “without merit” and that actions by his firm and the city of Richmond were “entirely within the law.”

“No investor in any trust will be made worse off by the sale of any loan,” Gluckstern said in the statement. “Rather, it is these trustees that are wasting trust assets at the expense of America’s pensioners by pursuing fruitless litigation.”

The court filing presents a number of potential legal hurdles in Richmond’s plan to assist underwater homeowners, including violation of the interstate commerce clause since mortgages are held by companies and investors outside of California. According to the suit, the city’s plan may be violating eminent domain law along with the US Constitution and the California Constitution.

Now, with the added weight of the federal housing authority threatening to choke off mortgage lending to Richmond, the city looks set to become the first battleground as a number of other cities around the country have also considered using eminent domain to seize underwater mortgages.

Mortgage Resolution Partners has reportedly marketed its eminent domain plan to two cities in California’s San Bernardino County, with formal discussions also taking place with four other state municipalities. According to the LA Times, North Las Vegas, Nevada has approved a similar plan, and both the cities of Seattle, Washington and Newark, New Jersey are considering adopting such a measure.

Although cities may be looking to help out homeowners who cannot cope with their mortgage payments, legal challenges by lenders, and now Freddie and Fannie could mean severely restricted lending and residents facing prohibitively high lending costs, which could in chill real estate markets.

The legal implications of using eminent domain by cities to seize mortgages, meanwhile, seems to just be scratching the surface.

Richmond Mayor Gayle McLoughlin responded defiantly to the lawsuit filed against the city.

"The fact these threats are being put out there are very, very disturbing — but we are not afraid to go to court," McLoughlin said. "We are looking forward to it, because we think fully that our legal reasoning will win."

Meanwhile, Cornell Law professor Robert C. Hockett, who has advised Mortgage Resolution Partners on the eminent domain proposal, said that the federal housing finance agency was acting beyond the scope of its authority by issuing threats.

"How many times must it be repeated that principal write-downs on deeply underwater mortgage loans increase the value of the loans — even while keeping homeowners in their homes and communities intact?" Hockett said.

"This is not only illegal, it is disgusting," he added.