Despite an initial win in federal court, will Richmond first have to prove that loans on over-mortgaged homes in its city are “trapped” to meet the “blight” criteria of California redevelopment law? A recent study by the Wall Street Journal indicates that Richmond would have to prove loans on over-mortgaged properties are “trapped” before they can justify there is public necessity to take the loans.

A “trapped” loan is where a government secondary mortgage market lender such as Fannie Mae or Freddie Mac won’t buy up sub-prime mortgages from primary lenders or other secondary lenders.  Therefore, homeowners with over-mortgaged homes cannot refinance by taking advantage of HARP or other mortgage payment programs. Their high-interest rate loans are “trapped” without any ability to refinance.

Richmond would have to prove “blight”

Wall Street Journal reporters Michael Corkey and Al Yoon sampled 36 out of 1,726 loans left in mortgage loan pool called CWABS Asset-Backed Certificates Trust 2006-7.  CWABS is an abbreviation for Country Wide Asset-Backed Securities; 836, or 48 percent, of homeowners in CWABS 2006-7 are current in their payments.  About half of the mortgages in CWABS 2006-7 are from California and Florida.

The U.S. Securities and Exchange Commission presently manages this loan pool.  Originally, the loan pool consisted of 5,954 mortgages.  The Journal did not report if the 4,228 loans no longer part of the pool were foreclosed, paid off, or refinanced by other lenders.

To undertake its eminent domain loan payment reduction program, Richmond must file a Resolution of Necessity in Contra Costa County Superior Court justifying the reason why taking mortgages out of a lender’s loan portfolio serves a public purpose.  Eminent domain law gives wide discretion to governments as to what qualifies as public purpose.  However, cities must typically prove “blight” to justify the use of eminent domain for economic purposes. Under California law blight is defined as:

“An area that is predominantly urbanized…and…it constitutes a serious physical and economic burden on the community which cannot reasonably be expected to be reversed or alleviated by private enterprise or governmental action, or both, without redevelopment.”

However, there is no public necessity to take loans on over-mortgaged homes where the homeowners can avail themselves of loan reduction programs, can short sale their homes for less than the loan balance, or are in default and can be foreclosed. Conceivably, all those actions would prevent or alleviate neighborhood blight in the long run.

There may be a private necessity to renegotiate an over-mortgaged home loan.  But aggregating the private necessity of all the over-mortgaged home loans in Richmond does not necessarily make a public necessity.

The City of Richmond incurred $7.9 million in 2012 in extra costs to prevent foreclosed homes from “blighting” neighborhood home values.  Therefore, it would only be those homes where there would be a public necessity to prevent blight. But those homes are no longer over-mortgaged.

Loans on over-mortgaged homes where homeowners are making payments are not causing “blight.”

To further learn how mortgages become “trapped” one has to understand how the primary and secondary mortgage markets work.

The secondary mortgage market

The secondary mortgage market is for the sale of securities or bonds in which the collateral is a pool of mortgage loans.  There are five layers of participants in the government-regulated mortgage market:

1) Borrowers.  These are homeowners whose loans have been re-sold by their bank to secondary banks;

2) Primary lenders or loan originators consisting of banks and mortgage banks;

3) Aggregators or secondary mortgage market banks like the federal government’s Fannie Mae  and Freddie Mac. Because of the risk of holding loans that might default, government-sponsored aggregators hedge their risk by “securitizing” them into bonds and other debt instruments.

4) Securities Dealers who sell the re-packaged loans to investors; and

5) Investors, which could be pension funds, insurance companies, and foreign governments.

One of the objectives of this many-layered loan system is to buy the loans off of the primary banks so they can make more loans to homeowners.  Each layer of the secondary mortgage market buys pools of loans based on risk-based discounts.

In the case of the City of Richmond’s mortgage consultant, Mortgage Resolution Partners is a mortgage securities dealer that buys loans on discounts.  It believes that if Richmond can take the loans on over-mortgaged homes away from primary lenders by eminent domain, it can re-sell the loans to investors at a discount and pass that discount back to the homeowners.  Mortgage Resolution Partners would also provide a $46 million windfall to the City of Richmond.

But an unresolved question is: who pays the investors of the primary and secondary mortgage lenders for the difference in the balance due on the loan and the discount price in the securities market?  The position of the City of Richmond and its mortgage securities consultant is: It's not their problem.  They believe they can stick the investors of primary banks with losses because the market value of the loan is worth less in the securities market.

However, an unresolved issue is: Would over-mortgaged homeowners eventually be stuck with paying off the investors of primary lenders when the homes are sold at a windfall profit?

Eminent domain law explicitly requires that the property owners be made whole for any losses. But what happens to the investors of the banks that are holding the loans?  So the whole scheme by the City of Richmond may backfire.  Here is where “trapped loans” come into the picture.

“Trapped Loans”

The City of Richmond’s scheme is to offer loan reductions to homeowners who are current on their loans payments.  Richmond would even go so far as to reduce the loan balances on million-dollar homes, which obviously are not blighted.

Richmond has a point that the loans contained in CWABS 2006-7 are high-interest sub-prime loans. CWABS 2006-7 is a high-interest rate loan pool averaging 8.5 percent, but ranging as high as 15 percent.

However, for homeowners to avail themselves of government loan payment reduction programs such as HARP (Home Affordable Refinance Program), their loan must be guaranteed by Fannie Mae or Freddie Mac.  Fannie and Freddie refused to invest in bonds loaded with so-called subprime loans.  The buzzword in the mortgage industry for high-rate loans that can’t be refinanced due to government rigamarole is “trapped.”

Because lenders have limited offering HARP 2.0 loans to only their own customers, they can raise rates on other homeowners with trapped mortgages and earn more than the market interest rate.

This raises the question, however, whether an eminent domain action is the appropriate legal action to correct this situation?  The definition of economic “blight” cited above specifies that it is where an economic burden is inflicted on a community that can’t be reversed or lessened by the private or government sectors or both.  The only types of properties that would meet this definition would be those with “trapped” mortgages.  All other types of homeowners with over-mortgaged homes have either private or public options available that would reverse or alleviate community blight.

Legally complex eminent domain actions in California are usually handled by bifurcating the trial into a “legal issues phase” and a “valuation issues phase.”

Such a pathbreaking use of eminent domain by the City of Richmond could take as much as a year just to decide the legal aspects.  Because Richmond may not be able to easily establish “public necessity,” it is unlikely that a court would authorize the automatic taking of mortgages with the value issue to be handled later.

But whatever happens in California’s court system, the matter of “trapped mortgages” is going to have to be raised.

By Wayne Lusvardi

With pension costs sapping budgets, governments at all levels are coming up with novel funding methods. The latest comes from the city of Richmond, which must deal with a looming 50 percent increase in pension costs amounting to $7 million per year over the next five years.

The city’s idea: use eminent domain to seize over-mortgaged home loans from lenders and re-sell them for a $46 million profit. That would help the city of 105,000 plug a $1.75 million decline in sales tax revenues and $7.9 million in additional costs from the negative effects of foreclosed properties in 2012.  About 49 percent of all mortgages in Richmond are classified as “underwater” — meaning the amount of the mortgage on a home greatly exceeds its current market value.

Richmond is another troubled East Bay city, just 12 miles up the 580 freeway from Oakland. Except for a few cities, such as university-town Berkeley, most of these cities have missed the tech prosperity of San Francisco and Silicon Valley to the southwest.

As the San Jose Mercury News reported last month, Richmond has $712 million in negative equity in over-mortgaged homes. That equates to $153,151 on average for each of the 4,649 over-mortgaged homes in the city.

According to Zillow.com, the median home value in Richmond dropped from $311,000 in 2008 to $157,000 after the bursting of the Mortgage Bubble. That’s a $154,000 decline, or 50 percent. Home values have begun rising lately, in just the last by 24 percent to about $200,000. But that’s still way off the peak of 2008, and could be another housing “bubble” about to burst.

Richmond tried to plug its looming budget shortfalls by putting a $6 million local sales tax increase called Measure D on the ballot in 2011. It would have boosted the sales tax rate from 9.75 percent to 10.25 percent. Voters heartily shot it down, 57 percent to 43 percent.

But voters would have no say on the new idea of eminent domain seizures of mortgages. No voters would have to approve mortgage eminent domain.  No municipal bonds would have to be issued or paid back with interest. The city would not have to fight labor unions to unwind pension obligation contracts.  It would be a new way to raise taxes: condemn mortgages from banks and re-sell them back to the same homeowners to reduce their mortgage payments.

How does secondary mortgage market work?

Mortgages are typically not held by the banks that originated the loans, but by what is called a secondary mortgage market. (This is not the same as getting a second mortgage on your home.)

Instead, the investors in the secondary mortgage market are typically pension funds, insurance companies, hedge funds and governments.

The mortgage market buys and sells mortgages based on discounts according to their yield and risk.  The discount is lower for loans where the borrower is making payments and higher for those who have defaulted.  A typical discount for a defaulted loan is 20 percent or higher.

How would mortgage eminent domain work? 

Richmond’s mortgage re-seller, Mortgage Resolution Partners, proposes to “cherry pick” the best performing mortgages out of a secondary mortgage market lender’s portfolio.  But it would buy these high-grade mortgages based on the 20 percent discount for low-grade “bad” mortgages.  It’s sort of like going to an auto dealer and picking only the new cars, but paying for them based on the discounted price as if they were used cars.  This is why the banking and real estate industries are strongly opposed to the use of mortgage eminent domain.

An example provided by Mortgage Resolution Partners: A home with a $300,000 mortgage is now only worth $200,000 in the open real estate market. The mortgage re-seller would buy that $200,000 loan for, say, $160,000, based on a 20 percent discount of the value of the real estate.  A new loan for $190,000 would be offered the homeowner by the mortgage re-seller. The mortgage re-seller would make a $30,000 profit ($190,000 minus $160,000).

The city’s mortgage re-seller would then split the $30,000 in profits: $10,000 for its expenses including a $4,500 fee or profit; $10,000 profit off the top for its investors; and $10,000 to the city.  A detailed breakdown this example is provided below.

In this example, the current owner, the secondary mortgage lender’s investors, would lose $140,000. (The original $300,000 mortgage would be cut down to $160,000; producing a $140,000 loss.)

The investors for Mortgage Resolution Partners would provide $190,000 in new loan money to the homeowner.  However, real estate brokers are afraid lenders would not make any more home loans in Richmond. The only market for homes could thus be “all-cash buyers,” which is what happened in the Great Depression of the 1930s. Thus, homeowners would get a mortgage reduction, but could not be assured of being able to re-sell their homes due to a lack of loan money for new buyers.

Mortgage Resolution Partners’ investors would make $10,000 in pure profit on top of whatever mortgage interest rate they would receive on the new loan.  So this is a scheme whereby Mortgage Resolutions Partners’ investors would reap a windfall at the expense of the secondary mortgage investors (pension funds, insurance companies, etc.).

The Mercury News reported there are 4,649 over-mortgaged properties (also called “underwater mortgages”) in Richmond.  The city would stand to reap about $46 million if the courts approved such a scheme.

You can’t take the well without buying the whole farm

An unaddressed legal obstacle for the city is whether eminent domain probably cannot be used to selectively take the best mortgages out of lender’s pool of loans without valuing the whole mortgage portfolio.  For example, under eminent domain law, government cannot take a farmer’s water well and underground water rights without paying damages to the whole farm.  How the city of Richmond and Mortgage Resolution Partners could expect any court to approve its scheme is a highly dubious assumption.

Richmond understandably is desperate. As with so many California cities, such as bankrupt San Bernadino and Stockton, it spent too much during the good times and now is struggling during the bad times.

However, here is the biggest unmentioned drawback of mortgage eminent domain: If it were enacted and passed the legal hurdles, what could stop a city from just seizing home equity, personal bank accounts or any other assets?

Detailed Breakdown of Eminent Domain Mortgage Example

By Wayne Lusvardi

In 1901, Frank Norris wrote a novel, “The Octopus: A Story of California.” The book became famous for its description of the monopolistic Southern and Pacific Railroad that dominated California a century ago.

Fast-forward to 2012 and the bankrupt city of San Bernardino, where the California Public Employees Retirement Fund is trying to become a new Octopus.

CalPERS asserts in bankruptcy court that it is a sovereign government agency that has police powers, the power of eminent domain and the power of taxation.  Police powers are the right of governments to enforce laws and regulations to protect public safety, health and welfare.  Eminent domain is the power to seize property for public use, while paying just compensation to the owners. The power of taxation means the constitutionally granted power of government to use coercive powers to impose and collect taxes.

CalPERS contends it is “an arm of the state” that is immune from the jurisdiction of the bankruptcy court. Thus, it asserts that the bankruptcy court cannot halt CalPERS from exerting its supreme right to the general funds of the city to meet its public-pension fund payments.  When the City of San Bernardino filed for bankruptcy, it stopped making pension payments to CalPERS. But CalPERS believes that it has police powers to protect government pensions as a new entitlement above even the duty of local government to protect its citizens from crime, fires and emergencies.

The Wall Street Journal reported: “If CalPERS has police power and sovereign rights, it could also seize private property or assess a special pension fee on taxpayers” — no matter that Proposition 13 requires a vote for any increase in taxes.  The Wall Street Journal cites the Fifth Circuit Court of Appeals, which ruled in 1940 that there is no preferential treatment for the state as a creditor. CalPERS asserts it can seize assets and leave the cash-strapped city of San Bernardino without money for essential public services such as police and fire protection.

CalPERS and underwater mortgage eminent domain

CalPERS often throws its weight around by using what is called “the CalPERS effect” to influence investment markets. It may not have monopoly power, but it has market power. This was described in a 2009 paper by Wilshire Associates Inc.:

“The California Public Employees’ Retirement System … has been a leading activist in the modern corporate governance movement since its beginnings in the mid-1980s. Over time, CalPERS gradually shifted its focus from more technical issues related to corporate control to fundamental issues of long-term corporate performance.”

The County of San Bernardino has recently retained Mortgage Resolution Partners to explore using eminent domain to condemn “underwater mortgages” as a way to bail out to several cash-strapped cities in the county. If over-mortgaged properties can be purged from lenders’ books, then CalPERS hopes the housing market will recover and tax coffers will refill and bail out the city and county pension funds.

Legal experts are doubtful that eminent domain can be used to take mortgages from lenders at less than full value, then pass the expected savings on to property owners with over-mortgaged properties.  Nonetheless, CalPERS believes it can trump even the courts, despite the checks and balances of the three branches of government: executive, legislative and judicial.

Executive agency

In reality, CalPERS is an agency under the executive branch of California government, with an unelected board that is not directly accountable to the public. Its board of directors is partly elected by CalPERS retirees. Other board members are appointed by the governor and the Legislature.  Also on the board are the state treasurer, controller, director of the Department of Personnel Administration and a delegate from the state Personnel Board.

There is no representation on its board to assure taxation with proportional representation or representation by taxpayer watchdog organizations.

What success CalPERS’ claims to sovereignty may have with a cash-strapped state court system that has a vested interest in any bailout of the state pension fund remains to be seen.

The Wall Street Journal calls CalPERS’ assertion of unlimited powers a “ploy.” Real octopus animals squirt an “ink” that serves to keep themselves hidden or as a decoy from predators. Expect some of the same from CalPERS.

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.

By Wayne Lusvardi

Will Americans be protected from eminent domain abuses? Eminent domain is where the government takes someone’s property, usually for a government purpose, such as building a school or road. But sometimes eminent domain is abused to take private property and give it to a private company, such as a big-box store or housing development.

Last week, California Lt. Gov. Gavin Newsom’s told mortgage banks and agencies of the federal government to “back off” from their opposition to the use of eminent domain in California to take “underwater mortgages.”

In response, on Sept. 13 Rep. John Campbell, R-Irvine, introduced the “Defending American Taxpayers from Abusive Government Takings Act” (H.R. 6397).  It would block local governments from pursuing the condemnation of so-called “underwater mortgages,” as is being proposed in San Bernardino County and elsewhere in California.

Campbell’s bill would work with secondary mortgage market lenders Fannie Mae and Freddie Mac, the Federal Housing Administration and the Veteran’s Administration to bring about mortgage reductions. The Federal Housing Finance Agency, overseer of both Fannie Mae and Freddie Mac, had threatened to take action against the use of what might be called “submerged eminent domain” before Rep. Campbell proposed his bill.

Underwater mortgages are really “over-mortgaged” loans where the amount of loan owed on a property is much higher than the current market value of a home.

For example, Campbell points out that San Bernardino County’s proposal would provide an incentive to appraise properties with underlying seized mortgages as low as possible to increase their potential profit to mortgage re-financiers. Stated differently: profiteering would be submerged out of the scrutiny of the public in rigged real estate appraisals.  What might be called “submergible eminent domain” would be used for underwater mortgages.

Campbell called such schemes “atrocious, corruptive, irresponsible and unconstitutional.”

Another Difficulty — A Tax Bill for Mortgage Reduction

The civil war over the use of eminent domain to acquire underwater mortgages has gotten almost all the media attention.  What has received less attention is the pending expiration of temporary federal legislation passed in 2007 that suspended the tax liability of homeowners who receive mortgage reductions of up to $2 million.

In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act, which expires at the end of 2012.  There is discussion to extend it, but Congress only has three months to act.  Newsom has made no known advocacy to extend the Debt Relief Act.  Instead he is championing the questionable use of eminent domain law to buy out underwater mortgages.

Creative Appraisals Proposed In-Lieu of Eminent Domain

Steven Gluckstern, chairman of Mortgage Resolution Partners, a private hedge fund proposing to condemn underwater mortgages, has proposed another “doozey” of a concept.  It would involve using creative appraisals instead of eminent domain to reduce mortgages.  Here is the Sacramento Bee described an example of his:

“A homeowner paid $300,000 for a house during the boom. That house is now worth $200,000, with a mortgage balance much higher than that. A city would seize the mortgage and pay the note holder $160,000. Gluckstern contends that would be fair-market value, after the potential costs of foreclosing on the mortgage are deducted.”

“The idea is not for the city to become a lender. Instead, he said, the homeowner would refinance his mortgage at $190,000, with help from Mortgage Resolution Partners. The extra $30,000 would be split between investors, local government and MRP, which would make a flat fee of $4,500 per transaction.”

A representative of the Securities Industry and Financial Markets Association called the above-described proposal a scheme for “short-term opportunistic investors to make a 20-to-30 percent profit” by “cherry pick(ing) the best loans out of a securitized poor and buying at a substantial discount.”

Prominent eminent domain attorney Gideon Kanner on his blog on Aug. 17 said, in reaction to the creative appraisal concept:

“Nobody seems to be asking why the awesome sovereign government power of eminent domain should be enlisted in quest of quick private profit…the public interest must predominate and the private benefit is limited to being incidental to it, as the court explained in [the case] County of Los Angeles vs. Anthony.” 

Kanner also asked what public interest is served in the above refinancing example when the loan in question is that of a performing mortgage where payments are being made.

Kanner also noted that, once the Pandora’s Box of eminent domain is opened up for underwater mortgages, the property owners could not be denied hiring their own attorney and appraiser and contesting any mortgage buyout or reduction offer.  If they won in front of a jury, the local government agency would be on the hook to pay court costs and the property owner’s litigation and appraisal fees.  This is minimally about $50,000 per case.

There is No Underwater Mortgage Free Lunch

The use of so-called “submerged eminent domain” has become a trendy cause by media elites Arianna Huffington and actor John Cusack.  However, no mention has been made that, in San Bernardino County, the proposal to use eminent domain would call for about 80 percent of all property owners to vote for higher property taxes to pay off the underwater mortgages of the other 20 percent of homeowners.

How long the concept of using eminent domain to reduce “underwater mortgages” would remain popular when all homeowners in a designated area would have to vote for higher property taxes remains to be seen.

By Wayne Lusvardi

What a ripoff. San Bernardino County wants to use eminent domain to let a private mortgage lender cherry pick “underwater” mortgages without paying damages to the lenders. Doing so supposedly would stimulate the resale market for homes.

The county’s policy would socialize the losses and privatize the gains of the underwater mortgages.  This would be done by acquiring underwater mortgages by eminent domain and re-selling them in the mortgage market for a discount.  Essentially, all taxpayers in the county pay would pay off the difference between the full acquisition price and the re-sell price through a municipal bond. The private mortgage company working for the county would make a fee from each sale.

Phil Angelides Previously Headed Mortgage Company

Mortgage Resolution Partners is the mortgage company selected by San Bernardino County to resell underwater home mortgages.  This company was recently headed by Democrat Phil Angelides, the former state treasurer lost a bid for governor in 2006. Angelides also was the chairman of the national Financial Crisis Inquiry Commission that mainly blamed banks, not government, for the 2007-09 economic crisis.

Angelides was also the co-developer of a residential subdivision called Laguna West in Elk Grove outside of Sacramento. Trulia.com reports there are 24 foreclosures and pre-foreclosures for re-sale in Laguna West today.

I’m no lawyer. But as an eminent domain appraiser for over 20 years, I would find the county’s proposal to condemn only “underwater mortgages” where the homeowner is still making payments as a likely violation of the legal rules for appraising just compensation in California.

The Entire Loan Portfolio Needs to be Valued

The mortgages to be acquired by eminent domain would have to be valued by appraisers for their “Fair Market Value.”  What would be appraised would not be the physical, tangible real estate of each home.  What would be appraised would be the intangible value of the underwater mortgages. An underwater mortgage is where the unpaid portion of the loan on the property exceeds the current open market value of the home.

The loans would have to be acquired for their remaining loan balance in order to make the lenders whole. Mortgage brokers or experts, not real estate appraisers, would subsequently be asked to value the mortgages for re-sale.  The mortgages would be valued not on the basis of the “comparable sales price” of actual homes, but the discount rate paid by mortgage brokers in the mortgage market.

According to securities expert and commercial real estate appraiser Steve Body of Eagle Rock, the discount is likely to be in the 50 to 60 percent range. This discount would have to be paid for by all county property taxpayers through a bond. Only the intangible loan value of the mortgages would be taken, not the physical real estate of each home with an underwater mortgage.

To comply with accepted “before and after” valuation methodology under eminent domain law in California, a condemning agency must retain an independent appraiser to value the “larger parcel” of the property to be taken.

For example, an agency may only want to acquire the farmer’s field. This is what is called a “part taking.”  But what has to be valued is the entire farm, including farm buildings, water wells, water rights, crops in place, chattels, any vertically integrated “ongoing” businesses, etc.

The same rule would likely apply in San Bernardino’s situation.  The “underwater” mortgages are part of a larger portfolio of loans.  Whole loan portfolios are valued in the private sector by discounting the cash flow from loan payments to their present value.  Loan portfolios likely have a mix of loans that are “not performing” (loan payments are in arrears) and loans that are “performing” (owner is current on payments).

As I understand it, what San Bernardino wants to do is cherry pick the best performing loans and leave the lenders with the loans that have been given Notices of Default and are in the process of foreclosure.  In short, they want to cherry pick the top of competitive lenders mortgage portfolios — all in the name of the “public interest.”

As many legal experts have stated, there is likely no doubt that the county has the right to define what is in the “public interest.”  The county can likely establish that it can take mortgages and allow a private lender to make a profit on them by reselling them.  This would be like taking someone’s home and allowing a private developer to upzone the land and make a profit on the higher use of the property for redevelopment.

But the county would have to re-write the Code of Civil Procedure and case law in California if it thinks it just wants to value those mortgages that are underwater and not the entire loan portfolio of the lenders.  This would be a gargantuan task because the county would have to appraise the entire loan portfolio of every lender, not just the 5,000 underwater mortgages it plans to take. We’re talking about countless thousands of loans valued as of a specific date. And the holders of the loans would have to be tracked down and identified, which may be an impossible task.

Severance Damages Also Need to Be Valued

Even if the entire loan portfolio could be valued, any “severance damages” to the remainder of the loans would also have to be appraised. The intent of just compensation is to “make the property owner whole,” not only for the property taken but also for any damages.

To use a farm example again, any damages to the remainder of farmland would have to also be appraised in addition to the value of the land taken.

As commenter Michael Baldridge appropriately wrote in the Wall Street Journal online:

“They want to seize the note. The note is worth what the note says. It’s the underlying collateral that is worth less. If they want to ‘seize’ the mortgage, they’ll have to pay the owner market value of the note, which is whatever is left on the mortgage. The underlying collateral is irrelevant. Using Mortgage Resolution Partner’s logic, the government could seize the note on a new car the second it drove off the lot, and the car is now worth 10% less. Then sell the car back to the owner for a 10% lower price (and lower payments), taking all the future payments while sticking the car dealer with the loss.” 

If the county cherry picked the best loans, then it would have to pay any damages to the remainder of the lender’s loan portfolio.

According to Body, if the county’s action results in leaving a greater proportion of non-performing mortgages in the lender’s loan portfolio, this would likely alter the portfolio to a status of “junk” (B-minus or lower credit rating).  The overall loan-to-value ratio, the percentage of under-performing loans, and the default rate would also have to be considered.

Uneconomic Remnant

If the remainder of a lender’s loan portfolio became unmarketable or worthless due to the county’s actions, the remainder of the portfolio could be deemed an “uneconomic remnant.” 

The term uneconomic remnant means: “a parcel of real property in which the owner is left with an interest after the partial acquisition of the owner’s property”; and which the government agency “has determined has little or no value or utility to the owner.”

In such an event — where the portfolio remainder has no value — the county could be legally compelled to acquire the whole portfolio.

Inverse Condemnation?

There are many other flaws in the notion to use eminent domain to acquire underwater mortgages to re-stimulate the housing market in San Bernardino.  Another of them is that such an effort is likely to impair the market value of properties for sale with no mortgages on them — where the homes are owned “free and clear” of any mortgage.  Bailing out the figurative water from “underwater” mortgages would flood the market with too much of a supply of homes, resulting in a decline in value.  Fire-sale prices would likely result as the pent up demand to sell previously over-mortgaged homes would flood the market and depress prices further.  The value of non-mortgaged homes would likely be dragged down along with the value of previously over-mortgaged homes.

This could give rise to what is called an “inverse condemnation” or “regulatory taking” lawsuit, where the property owner sues the government for a loss in value.

Fatal Flaw in County Proposal

Having to pay “severance damages” could be a fatal flaw that would likely make San Bernardino County’s proposal to acquire “underwater mortgages” economically infeasible and politically unacceptable.

If damages also had to be paid, the private loan reseller for the county would be unlikely to be able to make a profit.  Another option would be to have all property taxpayers in the county additionally pay for any damages to the remainder of the lender’s loan portfolio, as well as the underwater mortgages. Taxpayers might be outraged to have to pay damages as well as having to pay for what constitutes a gift to homeowners with underwater mortgages.

And if any homeowners file an additional lawsuit for “inverse condemnation” damages for impairing the market value and marketability of their homes, this could result in the county having to pay double damages to both the mortgage lender and third-party homeowners who couldn’t sell their homes.

San Bernardino County would be wise to ask the office of Attorney General Kamala Harris to issue a preliminary ruling of whether such a use of eminent domain is legal. And if so, the attorney general’s office should indicate whether the county would have to comply with the State Eminent Domain Code and the State Rule of Appraising Partial Acquisitions of property.

Advice also should be asked of eminent domain legal experts such as Gideon Kanner.

With San Bernardino city just declaring bankruptcy, and even faces a criminal probe, San Bernardino county shouldn’t compound the area’s economic problems.

By Wayne Lusvardi

In San Bernardino, the county has approved using eminent domain to seize bank-owned pools of “underwater mortgages” to get the county out of its over-indebted housing stagnation. The city of San Bernardino has the second highest poverty rate in the United States, after Detroit.

The cities of Fontana and Ontario have also approved joining the program.  The city of Hesperia, however, rejected the idea.  But such a bailout of underwater mortgages is likely to result in a number of foreseeable negative unintended consequences.

What happens if the county buys up underwater mortgages, but home values plunge again due to a double-dip recession triggered by an economic disaster, perhaps the European debt crisis? Economist Gary Schilling, who has called every recession correctly since the 1970s, is forecasting another 20 percent drop in national housing prices in 2012.

But this isn’t deterring those like John Husing, the chief economist for the Inland Empire Economic Partnership in San Bernardino, from promoting the notion of using eminent domain to acquire underwater mortgages and re-sell them to hedge funds.

Use of eminent domain to force loan write downs is the apparent brain child of Cornell University Professor of Law Robert C. Hockett in his June 2012 paper, “It Takes a Village: Municipal Condemnation Proceedings and Public/Private Partnerships for Mortgage Loan Modification, Preservation and Local Economic Recovery”.

Investopedia.com defines an underwater mortgage as “a home purchase loan with a high balance owed than the free market value of the home” on the open market. Homeowners with underwater mortgages typically cannot resell their homes unless they can come up with the cash to pay the loss off.

The median single-family home price in San Bernardino County is $158,500, as of May 2012.  The median home price in San Bernardino-Riverside Counties as of 2007 was $343,250. This reflects a 53.8 percent decline in value from the peak of the Housing Bubble.

Steven Gluckstern of Mortgage Resolution Partners, a private hedge fund proposing to batch the mortgages and re-sell them at a discount, says that roughly $1 billion would need to be financed to initiate eminent domain proceedings on 5,000 underwater mortgages.  The homes themselves would not be condemned.  That would reflect roughly $200,000 per home in loan write down needed.

Consider a home with, say, $315,000 loan balance as of 2012 — 50 percent its original value. In that case, a 60 to 70 percent loan discount would be indicated to provide a third-party investor a 10 to 20 percent profit. But this would result in a sale at less than the median home value of $158,500 today. It is not clear if homeowners would lose their rights to any future appreciation in their home as part of this deal.  If so, perhaps the entire property would need to be condemned as well.

A Redevelopment Agency for Over-Indebted Homes

The proposal to acquire underwater mortgages comes from Mortgage Resolution Partners, a San Francisco based group of venture capitalists. Mortgage Resolution Partners is led by CEO Graham Williams, who created Bank of America’s “award winning” Neighborhood Advantage low-income housing initiative.  Bank of America’s Neighborhood Advantage Program was essentially a “zero down” sub-prime loan program.

Reportedly, 150,000 homeowners have underwater mortgages in San Bernardino County.  About 20 percent of those mortgages — or 30,000 loans — are held in private mortgage-backed securities that could be acquired by eminent domain.  The eminent domain process would be funded privately. The re-selling of mortgages to hedge funds would be handled by private venture capitalists for a profit. But the county would hold the mortgages in a public/private joint powers agency.  Call it a “redevelopment agency for over-indebted homes.”

Eminent domain legal expert Gideon Kanner believes that eminent domain law is so broad in California that it could be stretched to allow the acquisition of underwater mortgages and still meet the legally required “public benefit” test.

Technically speaking, however, it is likely that a city could only legally condemn that portion of a mortgage that was “underwater” and not the whole loan. It would be unlikely that a “public benefit” could be justified for taking the portion of the loan that is not “underwater.”  This would be what is called a “partial taking” or “fractional interest taking.”  How that could be determined on 5,000 to 30,000 mortgages could be a logistic nightmare.

A ‘Lousy Idea’

But Kanner stated on his blog that this is a “lousy idea for a number of policy reasons”:

First, the county as condemnor would have to come up with the money to acquire the mortgages by a public-private partnership that would issue some sort of mortgage revenue bond.  Public-private partnership is a code word for what used to be called “redevelopment” in California until Gov. Jerry Brown and the state Legislature shut down redevelopment agencies in 2011.

Second, the standard for “just compensation” in eminent domain is Fair Market Value.  But banks and private mortgage lenders hold mortgages on their books for their higher “book value.”  The open market value of the homes serving as collateral for an underwater mortgage would be lower than the “book value” of the loans.

But you can’t use eminent domain law to acquire a home, or a mortgage, “on the cheap” at less than the balance owed on the loan.  The concept of just compensation is to “make the property owner whole.”  So eminent domain probably can only be used to force banks to sell their loans at full book value, not at a discounted value.

Nonetheless, mortgage loans would have to be sold at a discount in order for private investors to make a profit.  Thus, the county would have to be willing to buy loans at their face value and sell them for much less. The spread is called a discount, which reflects the margin of profit to the seller of the loans.

Steve Body, a commercial real estate appraiser and securities trader in Eagle Rock, California, stated that the expected discount on underwater mortgages would probably not be as low as the typical 10 to 12 percent in bankruptcy court.  He said it would also not be as high as 50 percent found in highly distressed assets.  That is because most homeowners with underwater mortgages are making their loan payments.  He believed a discount in the 20 to 40 percent range would be typical.  But Body stated that, paradoxically, if a public entity buys and guarantees payment on the loans, there would be less risk and thus less of a discount or profit for investors.

Both Body and Kanner mentioned that there would be another big impediment for banks selling their loans even at their full book value. Coercing banks to sell a portion of their loan portfolio might drop bank reserves to less than the minimum reserve of stress tests required by bank regulators.

Body cautioned that another impediment for banks could be what is called “fractional interest banking,” where banks loan out the same money, say, seven or eight times.  Could banks demand just compensation for the lost opportunity cost of a multiple of the book value of the loans? What bank would agree to a voluntary condemnation of their underwater mortgages and forego such profits?

Kanner warned of a repeat of the Savings and Loan Crisis of the 1980’s and early 1990s, when savings and loan banks had to sell their junk bonds at fire-sale prices by order of the federal government.  This resulted in the collapse of several savings and loan banks. 

Hazard of Non-Payments

But Kanner warns of even more “calamitous consequences.” There is hazard in reducing the loan balances on mortgages if borrowers are provided an incentive to stop making payments on their mortgages, hoping to get bailed out by the government.

And then there is the potential problem of the mass flight of property owners dumping their homes once their loans are reduced — to get out of California or take better jobs elsewhere.  Think of government-reduced mortgages as a one-way ticket out of San Bernardino.

And then there would be the prospective slippery slope problem that, if this were implemented in San Bernardino, where would it stop?  Other distressed counties would be politically pressured to reduce all the underwater mortgages in their jurisdictions, too.  A house of cards could result in the entire housing market collapsing.

And loans would likely be re-sold into a mortgage market at the same time as the federal government is dumping foreclosed homes on the market.

The proposal to use eminent domain to reduce over-indebted homes is filled with multiple unintended negative consequences.  But these consequences are foreseeable and thus potentially avoidable. Desperate cities should beware of hedge funds offering bailouts.