It’s no secret that California has been hit harder than most states by the housing crisis. Just east of Los Angeles, the county of San Bernardino has cities with some of the highest foreclosure rates in the U.S.

On July 18, the San Bernardino City Council declared a fiscal emergency and voted to file for Chapter 9 bankruptcy protection.

Attempting to stimulate the local economy, the county of San Bernardino entered into an agreement with two of its cities, Fontana and Ontario, to create the Homeownership Protection Program Joint Powers Authority (“JPA”) “to explore a variety of proposals to assist homeowners within their jurisdictions who are underwater on their mortgages.” Currently, the JPA is considering a controversial eminent domain plan put forth by Mortgage Resolution Partners (“MRP”), a San Francisco-based venture-capital firm, whereby (based upon publicly available information) underwater performing residential mortgage loans held in private-label securitizations would be seized, refinanced or restructured and sold to third-party investors, with the government recovering administrative costs and MRP earning a fee on each transaction (the “Program”). On July 13, the JPA held its first organizational meeting where it created the structure for moving forward and heard a handful of public comments from opponents of the Program. The next meeting of the JPA is planned for August 16. The Joint Exercise of Powers Agreement states that the Homeownership Protection Program established by the JPA “may include the Authority’s acquisition of underwater residential mortgage loans by voluntary purchase or eminent domain and the restructuring of these loans to allow homeowners to continue to own and occupy their homes.”

Eminent domain is basically the power of the government or quasi-government agencies such as highway commissions and utility companies to take private property for public use without the owner’s consent. Here, the state isn’t bull-dozing someone’s house because it’s in the path of the new highway being built. Instead, the homeowner (who is current on his mortgage payments) is allowed to stay in his home. The government would take his mortgage loan from its current holder and refinance or otherwise restructure the loan with a new holder such that the homeowner can now acquire equity and make lower mortgage payments each month. Novel idea — with some undesirable consequences.

On June 28, eighteen national, state and local organizations submitted to San Bernardino County a letter opposing the Program. The letter has drawn much attention to the issue.

On July 19, the Securities Industry and Financial Markets Association (“SIFMA”), issued a statement discussing the impact of the Program on the To-Be-Announced (“TBA”) market and introducing a policy regarding the interaction of eminent domain with TBA trading whereby loans to borrowers residing in areas that municipalities have initiated condemnation proceedings to involuntarily seize mortgage loans through their powers of eminent domain will not be deliverable into TBA-eligible securities on a going-forward basis.

Gregory Devereaux is the Chief Executive Officer of San Bernardino County and chairperson of the JPA. Despite reports that officials in San Bernardino County began talking with MRP about the proposal to seize underwater mortgages back in January 2012 (months before MRP’s involvement became public), and that the county signed an agreement with MRP not to disclose those communications, Devereaux stated in the July 13 meeting that the JPA was formed to explore ideas and programs to address the housing crisis “openly and with the community as a whole,” and he stated “there are currently no proposals or programs before this body.”

A professor of finance at the University of Chicago business school argues that restructuring debt contracts is a valuable and important part of the financial system because there comes a point when it becomes impossible to impose further losses on debtors, and that creditors are then expected to take losses on their positions. He says that in corporations and commercial real estate, such restructuring happens every day and notes it isn’t happening in the mortgage markets.

Proponents say the Program would target mortgage loans that cannot be written down but would otherwise be written down because it is in the interests of the investors to do so. They argue that the use of eminent domain is a means of getting around restrictive securitization documents that prevent mortgage loan modifications.

I did not get the impression that Devereaux is married to the eminent domain plan of attack but that he is a bit taken back by the fast and furious opposition. To me, he appeared to be pleading that alternative solutions to the housing mess in San Bernardino County be presented to the JPA. Hopefully some alternative ideas will come his way (I hear that other proposals are currently being prepared for submission) because the Program would not likely survive any of a plethora of legal challenges, a few of which are briefly discussed below.

The U.S. Constitution requires that private property be taken only for “public use.” The government may not take private property under the pretext of a public purpose when the actual purpose is to bestow a private benefit. Opponents are speaking out and concurring that if the Program is adopted, San Bernardino county residents will be subject to increased costs for credit because performing loans would now be subject to possible seizure by the government at a discount. This affects mortgage pool valuations and mortgage-backed securities valuations. Resultant losses would likely reduce access to credit for borrowers in San Bernardino County as mortgage interest rates increase, which would lead to decreased demand for homes in San Bernardino County, which would lead to lower home values… Therefore, it would be difficult for the JPA to demonstrate that the Program is necessary to attain the economic benefits touted.

MRP is certainly contemplating earning a dime here, so the existing mortgage holders must be paid less than fair market value, a violation of the Fifth Amendment because private property cannot be taken “without just compensation” (which would presumably be “fair market value”). The Program is designed to prevent a fair market value ascertainment. Further, pooled loans in securitizations arguably have even higher values than if valued independently, values above the amount I understand will ultimately be paid for the seized loans, at a huge loss to mortgage-backed securities holders. The Program assumes a “forfeiture discount” when determining the fair market value of a loan — an assumption that if a borrower is underwater, foreclosure is a certain result; but many performing underwater loans never default.

The Program may also violate the U.S. Constitution if it is found to interfere with interstate commerce such as disrupting the mortgage-backed securities market. And the Program may violate the U.S. Constitution if it is found to impair contract rights. The U.S. Supreme Court has repeatedly held that states have no authority to abrogate debts and transfer them to other private parties. If you are interested in citations to relevant case law, click here for the Dechert OnPoint.

There are a variety of California state laws that would likely be violated as well.

And if courts ultimately find that the fair market values for the mortgage notes are substantially different than MRP’s valuation, the JPA (and/or participating municipalities) may well be liable for paying the difference to the securitization trusts as just compensation.

Proponents and opponents of the Program do appear to agree on this: the Program, if adopted, will likely end up in court.

By Laurie Nelson.