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Extensive Litigation Would Precede Implementation of Eminent Domain

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As the financial services community has more time to digest a proposal that would have two cities and a county in California seizing ownership of negative-equity loans included in private-label mortgage-backed securities, it appears likely that a mountain of litigation would precede any actual implementation. In addition, such a strategy would likely prevent the return of private investors to impacted markets and raise the cost of credit.

The San Bernardino County Board of Supervisors approved the “Homeownership Protection Program” on June 19. The program is an amended resolution empowering local government to take possession of mortgages with loan-to-value ratios in excess of 100 percent through eminent domain. Two cities within the county, Ontario and Fontana, also approved a resolution authorizing a joint exercise of powers agreement.

The plan targets underwater mortgages in private-label securities that are not delinquent.

A host of trade groups quickly issued a joint letter warning the cities and county that such a strategy would only reduce the available credit to consumers in the area — which had the fifth-worst foreclosure rate of any major metropolitan statistical area in 2011 according to data from RealtyTrac.

Former Fannie Mae chief credit officer and American Enterprise Institute resident fellow Ed Pinto wrote last week that the investors promoting the plan, Mortgage Resolution Partners, “stand to profit handsomely” from the proposal — though they are pitching it as a costless way to address negative equity mortgages.

The prospect of private parties profiting from the government’s use of eminent domain at the expense of investors is susceptible to charges of rent-seeking and a political consideration that makes the proposal a challenge, according to a client newsletter from Citi Research Equities.

A report Monday from Fitch Ratings noted that there are 46,000 non-agency mortgages for $14 billion with LTV ratios in excess of 100 percent in the area impacted by the proposal. Around half of those loans are current.

Statewide, more than 590,000 non-agency mortgages for $241 billion have LTVs above 100 percent. On a national basis, 2.2 million loans for $589 billion are underwater.

Fitch indicated that the most troubling aspect of the proposal is the focus on borrowers who are current and would otherwise continue performing as expected but for the ability to restructure their mortgage through eminent domain.

The plan to condemn the most valuable loans in MBS pools — those that are paying — is also among Pinto’s biggest concerns.

But Fitch said that legal challenges to invoking eminent domain are likely and would make implementation slow and difficult.

Pinto wrote that the potential use of eminent domain will face serious legal challenges by bond holders — who stand to lose the most. He suggests that the issue could be litigated for years in the state and U.S. supreme courts.

But Citi said that legal experts it spoke with indicated that local governments might indeed be able to use eminent domain to seize underwater mortgages as a result of the U.S. Supreme Court decision in Kelo Vs. City of New London, which greatly expanded the government’s authority to seize private property under the auspices of eminent domain in order to promote economic development.

“As a result of that decision, litigation in eminent domain cases tends to focus less on the government’s right to take property and more on the value of the property taken,” Citi wrote.

Still, Citi sees extensive litigation centering on the valuation issue — a prospect that is likely to deter cities from taking the approach.

“In addition to pushing forward losses on performing loans, such a program could also have other unintended consequences including negatively affecting mortgage interest rates and credit availability in affected areas,” Fitch wrote. “Likewise, the implementation of this program could further weigh on private investor confidence and appetite for private-label mortgage-backed securities going forward.”

Pinto agrees that investor response could have a big impact.

He explained that the proposal is just another action against MBS investors as is the case with the multi-state servicer settlement that provided for principal reduction paid from investor funds.

“The result would be the further entrenchment of the government mortgage complex, which ultimately leaves the taxpayers holding the risk,” Pinto wrote. “Since this plan would be implemented locally, investors could decide not to invest in securities from these areas, raising rates for many borrowers in the affected localities, thereby making matters worse.”

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