A controversial proposal by three California municipalities to seize underwater mortgages through eminent domain could face significant legal challenges because state law prohibits local governments from taking property and conveying it to a private company, lawyers say.

But San Bernardino County and the cities of Ontario and Fontana are pressing ahead anyway, and the fate of their plan could hinge on this legal question: Is seizing a loan the same as seizing a private residence?

"This is a purely novel creature," says Bronwyn F. Pollock, a partner in Los Angeles at the law firm Mayer Brown, which held a webinar Thursday to discuss the legal issues associated with the plan. "There is no case law so this requires us to analyze and apply statutes to something because that's never been tested before."

At issue is Proposition 99, a California law passed in 2008 that forbids municipalities from taking property and then transferring it to a private company. Under the proposal, the county and local governments would buy underwater loans with the help of a San Francisco venture capital firm, Mortgage Resolution Partners, which would then take over the loans and restructure them.

The law was passed in response to a Supreme Court decision that allowed the city of New London, Conn., to take private homes and give the land to developers for a larger redevelopment project intended to improve the corporate headquarters of the pharmaceutical giant Pfizer.

The California municipalities often cite that 2005 decision in the case of Kelo v. New London as validation of their plan to seize underwater mortgages, but Pollock argues that Prop 99 could trump the Supreme Court ruling.

"This may be dead on arrival," she says. "There is going to be a legal debate about whether or not the loans can be acquired and given to a private party."

Even absent Prop 99, Pollock questions whether the municipalities have a case. In the Kelo decision, the court ruled that properties could be transferred to private entities if they are part of larger development plan. Instead, the plan is for the county and the cities buy up the loans and have a private company restructure them, for a profit, so that underwater borrowers can stay in their homes.

"If the property is being seized as part of a larger development plan, that might work as a general matter," Pollock says. "Kelo is introducing this idea that the use of eminent domain to benefit a private developer may be appropriate as long as it's part of a private development plan."

It is unclear how San Bernardino County will overcome the legal objections. The county only recently passed a resolution authorizing its staff to create a request for proposal to consider ways to address the glut of underwater borrowers and is expected to hire legal counsel as part of the request.

Legal issues also could hound the cities of Ontario and Fontana, which recently joined forces with San Bernardino County to form a Joint Powers Authority to explore the use of eminent domain. Because those cities do not have charters, they are limited by existing law that allows loan seizures only for "issues of blight," Pollock says.

There is little blight associated with such loans since the proposal calls for the seizure of underwater but performing loans, in which the borrower is still paying their mortgage (and presumably mowing the lawn and keeping up the property) but owes more than the home is worth.

Much is at stake for Mortgage Resolution Partners, which conceived the idea of seizing and restructuring underwater mortgages, and has taken the proposal to other municipalities, including Berkeley, Calif., Chicago, and Suffolk County, on the eastern portion of Long Island.

Mortgage Resolution Partners has proposed raising money to help local governments purchase underwater loans and assist in restructuring them for a profit. The firm would receive a fixed fee of $4,500 per loan and earn returns of 20% to 30% of each loan's value by refinancing through the Federal Housing Administration.

That proposal has raised the ire of private-label mortgage-backed securities investors because Mortgage Resolution Partners intends to pay just 75% to 80% of the value of the property, essentially taking a "foreclosure discount" even though the properties are not being foreclosed upon.

Indeed, municipalities would likely have to get the consent of the trustees of private-label mortgage-backed securities to proceed with Mortgage Resolution Partners' plan. That is highly unlikely since mortgage investors are vehemently opposed to all eminent domain proposals because they would be paid less than fair market value for the loans, says Chris Killian, managing director of the Securities Industry and Financial Markets Association, which represents large investors, banks and asset managers such as BlackRock and Pimco.

"It's hard to see a public purpose in helping out one group of people by taking money by another group," Killian says. "The cities are putting themselves at risk by relying on [Mortgage Resolution Partners'] judgment of the payment for the loans."

Another twist is that eminent domain in California historically was governed by hundreds of local redevelopment agencies. But redevelopment agencies were abolished last year because of the state's budget woes so new laws would have to be enacted to give the municipalities such authority.

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