In a contentious 4-3 decision and amid more than 300 community members on both sides of the issue, the City Council for the City of Richmond voted to continue pursuing its eminent domain plan in the early morning hours of Wednesday, September 11. The council also rejected two related measures, one that would withdraw the letters threatening eminent domain and another requiring Mortgage Resolution Partners, the firm providing financial backing for the City’s plan, to obtain insurance to insulate the city from legal liabilities.

Last month, the City of Richmond sent letters to mortgage companies seeking to purchase 624 loans secured by underwater properties (homes with mortgages greater than their current market value). The City’s letter threatened to use its power of eminent domain if investors resisted selling the loans.

The proposed use of eminent domain has sparked concern across the financial services industry. The plan would work like this: a home may have a mortgage in the amount of $500,000 but may only have a current market value of $250,000. Using its eminent domain power, a city could argue that the loan is only worth $200,000, calculated by discounting the home’s current market value by a spread determined by the city, presumably to account for the risk of repayment, costs to exercise remedies, etc. If a judge agrees with the city’s valuation of the loan, the city (and its financiers) would purchase the loan for $200,000 from the existing lender. Then, the city could offer the homeowner an opportunity to refinance their mortgage with a new loan of $240,000. The new mortgage would be less than the current market value of the home, but would also provide $40,000 to the city in order to defray costs and to provide profits for the city and its investors.

The City of Richmond argues the benefits of this plan will reach beyond the individual homeowners refinancing their mortgages by reducing the number of foreclosures, which have negatively impacted property values and eroded the tax base. Opponents believe this would make borrowing more expensive for everyone and simply shift profits from current investors to financiers of such programs. Others warn the practice could lead lenders to shy away from lending in communities with unstable real estate markets, primarily in low income and minority communities.

Already, a lawsuit has been filed in the Northern District of California by trustees of mortgage bonds (Wells Fargo Bank, National Association, et. al v. City of Richmond, California, et al (Case No. 13-03663)). The lawsuit seeks to enjoin the City of Richmond from moving forward on its plan and alleges that the proposed use of eminent domain is an unconstitutional violation of interstate commerce. The lawsuit also alleges that the public purpose requirement for exercising eminent domain has not been satisfied.

Implementation of the plan may be further impeded by the Federal Housing Finance Agency (FHFA). The FHFA, which regulates Fannie Mae, Freddie Mac and the twelve Federal Home Loan Banks, issued a statement on August 8, 2013 stating “use of eminent domain to restructure existing financial contracts… presents a clear threat to the safe and sound operations” of the entities under its purview. It went on to state that it may initiate legal challenges against localities who employ eminent domain to restructure mortgages or direct its entities to restrict or cease business activities in such jurisdictions.

What happens next will be closely followed by the banking industry and local governments alike. In fact, the Wells Fargo v. City of Richmond case has already garnered the attention of the American Bankers Association, the California Mortgage Bankers Association and the U.S. Chamber of Commerce, each of whom have filed a motion for leave to file amicus briefs in the case. Moreover, several other municipalities, including Newark, Seattle, North Las Vegas, Nevada and El Monte, California are exploring the eminent domain strategy.