The nation's top housing finance regulator threatened to choke off mortgage lending in cities that use eminent domain to seize underwater loans from lenders.
The salvo from the Federal Housing Finance Agency came Thursday, on the heels of a lawsuit directed by major Wall Street firms and U.S.-sponsored mortgage giants Fannie Mae and Freddie Mac against the Bay Area city of Richmond.
Richmond is the first to push forward with the plan, also being debated in cities across the state and nation. Richmond wants to require lenders and investors to sell underwater mortgages at a deep discount. The city would then refinance borrowers into more-affordable mortgages.
The federal housing agency, which regulates Fannie and Freddie, on Thursday made clear it doesn't intend to let this happen. The agency said it would instruct Fannie and Freddie to "limit, restrict or cease business activities" in any jurisdiction using eminent domain to seize mortgages.
The move would be a "huge blow" to the city of Richmond, said Guy Cecala, publisher of Inside Mortgage Finance.
"It is pretty much a death sentence these days in terms of mortgage financing," Cecala said. "It is sort of an atom bomb solution, and the real question is would they pull the trigger on it, or is it just a threat? But it is the kind of thing they could do fairly quickly."
Executives and legal counsel for Fannie Mae and Freddie Mac also singled out the eminent domain plan this week during conference calls with journalists to discuss second-quarter financial results.
The use of eminent domain is "a serious issue that has the potential to unsettle investors in mortgage securities," Fannie Mae Chief Executive Timothy J. Mayopoulos said Thursday.
On Wednesday, the two mortgage giants joined with big bondholders in suing Richmond, seeking an injunction against the city and its private partner, Mortgage Resolution Partners. The city's program could cause investors losses of $200 million or more if the plan goes forward, the lawsuit said.
The other bondholders directing that suit include Newport Beach-based Pacific Investment Management Co., BlackRock Inc. of New York and DoubleLine Capital of Los Angeles. In a separate action filed in the same San Francisco court Wednesday, the Bank of New York Mellon also sued the city and Mortgage Resolution Partners.
Eminent domain is typically used to seize land, not loans, usually to take over blighted property or land needed for projects such as a highway. But the unorthodox plan by Mortgage Resolution Partners would use the power to force private investors to sell mortgages.
Mortgage Resolution Partners first marketed the plan last year to San Bernardino County and two of its cities, Fontana and Ontario. The firm is now contracting with the city of Richmond to implement the strategy.
Other cities considering the proposal include El Monte, which weighed the idea behind closed doors during a City Council meeting Tuesday. At least three other California municipalities — La Puente in Los Angeles County, and Orange Cove and San Joaquin in Fresno County — are also consulting with Mortgage Resolution Partners. Half a dozen other California cities have had less formal discussions with the firm.
North Las Vegas, Nev., has also approved a similar plan, and Seattle and Newark are also considering adopting the measure, according to Mortgage Resolution Partners.
That makes the working-class city of Richmond, situated just north of Berkeley in the East Bay, an important test case. The hardscrabble town of 106,000 people has sizable black and Latino populations and was hard hit by the housing crisis, with homeownership rates well below the national average.
Even with prices rebounding in Richmond, many residents still struggle with outsized mortgage payments, said Richmond Mayor Gayle McLoughlin.
"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."
Cornell Law professor Robert C. Hockett, who advised Mortgage Resolution Partners on the proposal, said that the federal housing finance agency was acting outside of its authority by issuing its 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."
In their suit, the mortgage holders acting on behalf of Fannie, Freddie and Wall Street firms argue that the eminent domain plan violates the law on a number of grounds. The suit argues that the plan targets mortgages for a purely private use, which is a violation of the takings clause of the U.S. Constitution, the California Constitution and of eminent domain law.
By reaching beyond the city's borders to take control of loans, the city also may be violating due process requirements. And, the suit argues, by rewriting mortgage contracts, the program violates the interstate commerce clause of the U.S. Constitution, likely resulting in major harm to the national mortgage and housing industries.
Also, by eradicating the debts of some local residents at the expense of out-of-state creditors, the plan would also violate the contract clause of the U.S. Constitution, the suit alleges.
"Under this scheme, 100% of the cost will be borne by pensioners, savers and in some cases, the taxpayers who currently own these mortgage backed securities," said John Ertman, a lawyer at Ropes & Gray in New York who is acting as counsel to the firms behind the suit. "A hundred percent of the profit will be split between [Mortgage Resolution Partners] and the city of Richmond."
Jim Puzzanghera in Washington contributed to this report.