Three large bond investors filed a lawsuit Wednesday against the city of Richmond, Calif., to stop it from buying and restructuring underwater mortgages through the use of eminent domain.

The lawsuit was filed in federal court in San Francisco by the trust units of Wells Fargo (WFC) and Deutsche Bank, acting on behalf of three institutional bond investors: BlackRock, DoubleLine and Pacific Investment Management Co., known as Pimco.

Last week, city officials in Richmond sent offer letters to 32 trustees and servicers demanding that they sell the city 624 loans at reduced prices or face seizure of the properties through the powers of eminent domain.

The lawsuit could prove to be the first legal skirmish testing whether municipalities have the legal right to seize properties from private investors in an effort to help homeowners avoid foreclosure.

John Ertman, a partner at Ropes & Gray LLP, says the purpose of the suit is to protect retirees and savers in pension and 401(k) plans from the "unlawful and unconstitutional seizure of private property and prevent severe damage to the country's home mortgage market."

The lawsuit alleges the city of Richmond's program constitutes an illegal seizure for private, not public use, and violates interstate commerce laws by attempting to rewrite mortgage loan contracts with out-of-state creditors.

The suit also claims that public and private pension plans are being targeted by "an elaborate profit-driven scheme" implemented by the city and Mortgage Resolution Partners, a San Francisco investment firm that has previously been unsuccessful in getting other municipalities, notably Chicago and the city of San Bernardino, Calif., to move forward with similar plans.

The city and Mortgage Resolution Partners are offering to buy the loans at steeply discounted prices, typically 80% of the value of the home or less than the outstanding amount owed by the borrowers. MRP then plans to refinance the loans using federal programs.

Banks, mortgage lenders and investors in mortgage-backed securities have launched a massive public relations campaign against the city, through their trade groups, claiming residents will be restricted from buying homes because of the threat of eminent domain. The groups claim banks will require high down payments and charge higher interest rates to current borrowers because investors cannot gauge the risk of a potential seizure of the underlying collateral backing the loans.

"This unconstitutional application of eminent domain will be devastating for mortgage finance both public and private," Ertman said in a press release. "It will completely undermine the willingness for private capital to return to the mortgage markets."

On Thursday, the Federal Housing Finance Agency issued a statement saying the use of eminent domain to seize mortgage loans "presents a clear threat to the safe and sound operations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks."

Alfred M. Pollard, the FHFA's general counsel, wrote in a 7-page memo that FHFA may initiate legal challenges, direct its regulated entities to limit or cease doing business within jurisdictions that adopt eminent domain to restructure mortgages, or take other actions to respond to market uncertainty or increased costs.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.