By Wayne Lusvardi

Call it “lawyer wars.” The city of San Bernardino’s bankruptcy case is getting messy, pitting lawyer against lawyer.

Last week federal Judge Meredith Jury barred the law firm Winston and Strawn from representing a major bond insurer, National Public Finance Guarantee, in the city’s legal battle with the California Public Employees’ Retirement System. CalPERS asserts it has first claim over city revenues for its pension fund over the claims of bondholders or even city funding for public safety.

The reason for Jury’s action: the attorneys from the law firm of Winston and Strawn had also worked on the case of another bankrupt city, Stockton, but in that instance for CalPERS.

She said, “No matter how good the ethical firewall is, there will always be a sense that there is a fox in the henhouse.”

CalPERS filed a complaint alleging that Winston and Strawn recruited members of the bankruptcy team from K&L Gates, which had represented CalPERS in the Stockton case. Winston and Strawn contended that the selected attorneys would be internally “screened” off from San Bernardino case.  CalPERS alleged the attorneys were “tainted.”

“Screening” is typically a practice of large law firms who hire attorneys from smaller firms.  It involves creating a communication wall inside the law firm to restrict contamination of a case.

As reported in the Stockton Record, Professor John Sprankling of the University of Pacific’s McGeorge School of Law in Sacramento said lawyers switching sides in the San Bernardino case did not necessarily create a conflict of interest.  He said it was a common practice in large law firms the size of Winston and Strawn.

Is CalPERS trying to shift losses onto insurers?

But that argument didn’t convince Jury, who disqualified the Winston and Strawn firm in a huge blow to National Public Finance and Guarantee. Having to switch to new attorneys mid-stream in the case will likely weaken National’s legal defense until its new attorneys can get up to speed.

In the related pre-bankruptcy negotiations for the city of Detroit, Mich., National Public Finance and Guarantee and other insurers could be forced to take a loss — not bondholders, the city or its pension fund.  So in the high stakes chess game of the San Bernardino-Stockton bankruptcy cases in California, it may be the bond insurers that also will be forced to take a loss. Thus, weakening the bond insurers in the San Bernardino case came at a critical time when there is an apparent legal strategy by public pension funds to try to shift losses onto bond insurers.

Stockton was the first city to try to use a bankruptcy action to shift losses onto bondholders.  The Detroit case is the first to try to peg losses on bond insurance companies.

San Bernardino may be the first to try to knock out opposing legal counsel for bond insurers. But why?

Even if San Bernardino’s second largest creditor — Wells Fargo pension obligation bondholders — was forced to absorb a loss, doing so would only represent 15 percent of all debt owed by the city.  CalPERS is San Bernardino’s biggest “creditor,” reflecting 48 percent of all debt owed as of August 2012. Thus, there is a shift toward looking to bond insurers rather than only creditors to additionally absorb some of the losses.

In the Stockton bankruptcy case, a ruling is scheduled for July 2 on the matter of lawyers switching sides.

The biggest creditors to the City of San Bernardino are:

Selected Large Creditors — City of San Bernardino

By Wayne Lusvardi

What are called “nail houses” in China may be coming to the county of San Bernardino in 2013 by using eminent domain as a bail out from unfunded public pension debts.

The photo at right shows a property that has gained worldwide attention as a holdout from a freeway construction project in China.  A now famous duck farmer owned the home — recently demolished after the owner finally “accepted” the Chinese government’s offering price.  Holdout houses in China are called “nail houses” because homeowners refuse to be “hammered down” in price.

Mortgage Resolution Partners is a private mortgage hedge fund manager hired by the county of San Bernardino. It now has vowed to move ahead with its controversial plan to use eminent domain to buy out “underwater mortgages” from lenders. MRP’s plan is to take the mortgages by force of eminent domain law from lenders, reduce the amount owed on each loan and let the homeowners continue to live in their homes while making lower payments.

In San Bernardino County, it is mortgage lenders holding so-called “underwater mortgages” that are resisting being hammered down in price for their mortgages. Lenders are not going to sit still and allow performing mortgages to be taken “on the cheap” so that some politically connected mortgage consulting firm can reap an estimated $135 million windfall without a fight.

MRP would get a set fee of $4,500 per loan write down for some 30,000 underwater mortgages. It is estimated there are 150,000 underwater mortgages in the county where the loan owed is higher than the market value of the home.

As renowned California eminent domain attorney Gideon Kanner wrote on Nov. 27:

“[I]t seems likely that the realization has sunk in that the exercise of the power of eminent domain requires payment of just compensation. Evidently no one has thought through what that would entail quantitatively, and no one is eager to put up the money required to find out. Remember that the statutory “fair market value” that is the usual measure of “just compensation” requires payment of the highest price the property in question would bring if sold in a voluntary transaction by a knowledgeable but unpressured seller to a knowledgeable but unpressured buyer. And, as far as we can tell, nobody knows what the highest price of an underwater but performing mortgage is.

“Our perception is that at first, the promoters of this scheme saw it as easy pickings; they would pick up some performing but underwater mortgages at way below their value and clean up by letting the occupant-homeowners take over the debt service using a lower mortgage balance. But apparently, performing mortgages cannot be picked up for peanuts even if they are underwater. They represent a cash stream which no one is going to give away.” 

Who Would Pay Off Lenders?

Even if MRP could legally pull off taking mortgages from lenders, there are additional, near-insurmountable, problems.  Who would pay the lenders for the difference between their loan value and the write-down value? It is likely the county would have to float a general obligation bond to be paid off by all property owners on their tax bill.  This might trigger Proposition 218, which requires any tax to be put to a vote.

According to the U.S. Census, there are 702,060 housing units in San Bernardino County.  Whether the county and MRP could persuade 552,060 homeowners without underwater mortgages to vote for an in increase their property tax obligation by an estimated $27,710 per property is highly doubtful.

MRP and the County know there is no magic hammer in eminent domain law that can make disappear the amount of the mortgage over the home’s market value without having to pay for it.  They apparently believe they can influence a judge to relax the definition of Fair Market Value so that eminent domain can be used as a bailout.

The mortgage industry, the local real estate industry, and even the federal government are opposed to the abuse of eminent domain law in this way. Even if taking mortgages is somehow deemed lawful, it would lead to instant disinvestment in the county and other property owners would likely be unable to sell their homes. But governments in California are apparently concerned about saving their own skin, not that of homeowners.

Desperate Governments are Seeking Legal Hammer

The city of San Bernardino and many other cities in the county are desperate. The city of San Bernardino has filed for bankruptcy.  It has also stopped making its bi-weekly $1.2 million payments to CalPERS for public employee pensions. In turn CalPERS has filed suit for the amount of the pension obligation in arrears. The city of San Bernardino is a worse case than the bankrupt city of Stockton, which chose to keep making CalPERS payments.

San Bernardino’s unfunded pension obligation is reported at $143 million. But that would rise to $319 million if the city wanted to exit CalPERS.  Cal-PERS wants to conduct its own sort of eminent domain action by using the force of a court action to collect the city’s contributions to its pension fund over all other obligations.

If CalPERS is able to get first dibs on the city’s treasury, the city attorney has warned residents not to rely on the hammer of the law to protect them but to “lock their doors and load their guns.” The reason: There won’t be enough money left for police protection if full public pensions need to be paid. This is probably not just a verbal threat to influence public opinion about the bankruptcy and CalPERS lawsuit. The giant wave of unfunded pension debt now pressing on the city would result in their not having enough money to fund but a skeleton crew of police and firemen.

CalPERS could bring about the unraveling of the rule of law in San Bernardino.  The city attorney has pointed to the rising murder rate in the city as a signal of what the city is facing in the future.

Look for Pounding Out of Market Value Loophole 

MRP has been working with the city of San Bernardino, liberal academic legal experts, CalPERS and law firms for months trying to devise a way to use eminent domain law to take selected mortgages from lenders on the cheap.  As someone who was an eminent domain appraiser for 20 years, look for MRP’s attorneys to exploit the rarely used alternative definition of Fair Market Value in California’s eminent domain law, which states:

“The fair market value of property taken for which there is no relevant, comparable market is its value on the date of valuation as determined by any method of valuation that is just and equitable. (Source: Section 1263.310 (b) — California Code of Civil Procedure).  

The words “just and equitable” in the above definition are likely to be twisted to bang open the court door for the use of eminent domain for social justice bailouts. Attorneys representing mortgage lenders, local realty associations, or property rights groups should anticipate that MRP might base its use of eminent domain on the above loophole.  The conventional definition of market value is a closed door that probably can’t be hammered open to meet MRP’s objectives.

County Property Owners are Nails for Hammering

Who is eventually going to get hammered down — countywide property taxpayers, CalPERS or mortgage lenders?  That remains to be seen. Right now it is a legal game of who ends up getting to hammer the other money players. San Bernardino County property owners need to be vigilant because neither the city nor the state nor CalPERS wants to take a hit from a hammer.

That makes property owners a vulnerable target for some sort of “creative eminent domain” that shifts the city’s pension obligations onto them. Look for the rise of a property owner movement in the county to protect homes from having to take to hit of about $27,710 in debt added to each home (with interest it would likely be about three times as much over 30 years).

Paraphrasing a popular proverb: “If all you have is a hammer, everything may become a nail house” in San Bernardino in 2013.