Lawsuit Against California’s Robbing Homeowners of National Mortgage Settlement Funds Has Very Good Chance of Success

By David Dayen, a lapsed blogger, now a freelance writer based in Los Angeles, CA. Follow him on Twitter @ddayen

Late on Friday, a coalition of African-American, Latino and Asian-American groups sued California Governor Jerry Brown, demanding that he return $350 million stolen from the state’s share of the National Mortgage Settlement to plug a budget hole.

California is far from the only state to divert money given as a penalty for homeowner abuse into the General Fund; in fact, less than half of the $2.5 billion given to states in the settlement actually went to housing (and that’s a generous rendering which counts things like North Dakota spending to increase housing stock in oil country for police officers, when that has nothing to do with compensation for abuse). In fact, consumer groups in Arizona already tried to sue to force $50 million that went to their state’s General Fund back into the hands of homeowners. But a Maricopa County judge ruled that the language of the consent order was sufficiently broad to allow the diversion of funds.

Does that mean that this California lawsuit is nothing more than a show of vanity, destined to fail? Absolutely not. In fact, by a strict reading of the case law and the documents in the case, the plaintiffs should win in a walk.

First of all, the plaintiffs have as lead counsel Neil Barofsky, the former Special Inspector General of TARP (mentioned in my previous piece, so I guess it’s Barofsky day here), who has shown his diligence and attention to these types of matters (his firm is doing the case pro bono, with the potential provision of fees by the court if they win the case). More important, not only is the state law, which governs in this instance, more favorable in California to a positive ruling, but the language of the consent decree for California is more airtight.

In general, the NMS consent judgment stipulated that “To the extent practicable, such funds shall be used for purposes intended to avoid preventable foreclosures, to ameliorate the effects of the foreclosure crisis, to enhance law enforcement efforts to prevent and prosecute financial fraud, or unfair or deceptive acts and practices and to compensate the States for costs resulting from the alleged unlawful conduct of the Defendants.” But within that, each state added further instructions. Arizona’s were identical to the above, and the judge in their case used the “ameliorate the effects of the foreclosure crisis” clause to say that the crisis caused a decrease in revenue through property taxes, therefore it was OK to divert the money to the General Fund to pay it back.

However, California’s individual instructions for its $410 million share had different language:

Ten percent of the payment shall be paid as a civil penalty and deposited in the Unfair Competition Law Fund;

The remainder shall be paid and deposited into a Special Deposit Fund created for the following purposes: for the administration of the terms of this Consent Judgment; monitoring compliance with the terms of this Consent Judgment and enforcing the terms of this Consent Judgment; assisting in the implementation of the relief programs and servicing standards as described in this Consent Judgment; supporting the Attorney General’s continuing investigation into misconduct in the origination, servicing, and securitization of residential mortgage loans; to fund consumer fraud education, investigation, enforcement operations, litigation, public protection and/or local consumer aid; to provide borrower relief; to fund grant programs to assist housing counselors or other legal aid agencies that represent homeowners, former homeowners, or renters in housing-related matters; to fund other matters, including grant programs, for the benefit of California homeowners affected by the mortgage/foreclosure crisis; or to engage and pay for third parties to develop or administer any of the programs or efforts described above.

The 10% was put into the Unfair Competition Law Fund, leaving about $369 million left. That was supposed to go to a Special Deposit Fund. As the complaint points out in very plain language, the Governor simply broke the law when he drained the money:

There is no question that the $369 million at issue was required to be deposited into a Special Deposit Fund. There is no question that this sum was supposed to be devoted to the specific purposes for which the Special Deposit Fund was created, as expressly recited in the pertinent settlement documents co-signed by the California Attorney General’s Office. There is no question that most of the money was instead diverted to the State’s General Fund to pay off the State’s general debts. And there is no question that the Governor has projected a large budgetary surplus for 2014 and beyond, but has given no indication in his budget that he intends to replenish the diverted funds, now or ever.

About $19 million was spent on housing counselors and payment for the state’s independent settlement monitor. The rest, $350 million, went right into the General Fund. The only vaguely housing-related use of that money was to pay off debt service on affordable housing bonds that predated the settlement.

In California, you simply cannot drain a Special Deposit Fund without any provision to pay the fund back. This all occurred when California had budget deficits of around $15.7 billion; now the state is in surplus, with rainy day funds and reserves far larger than the $369 million the Governor stole. So it’s completely feasible to return the money to the Special Deposit Fund now.

In fact, it’s settled law in California that the state must pay it back, with case law going back to the 1930s. Here’s the case, Daugherty v. Riley, from 1934. A Special Deposit Fund was created for the office of the Commissioner of Corporations, Daugherty, and the legislature similarly removed the money for the General Fund. The state Supreme Court ruled that the money had to be returned eventually. Here is the key section:

What has been said is not to deny power upon the part of the legislature to transfer a special fund reserve temporarily from one purpose to another under the authority of section 444 of the Political Code or other authority to like effect. But when these diversions are made the transfers are under the section deemed a loan from the special fund to be returned to that fund as soon as funds are available. This right of transfer established by said section 444 is specifically declared not to warrant the transfer of any money from any fund so as to interfere in any manner with the objects for which such fund was created.

Given the surplus, it’s beyond doubt that money for the Special Deposit Fund, set up to distribute benefits to homeowners who suffered at the hands of unscrupulous mortgage servicers, is available to be returned. I suppose a judge who really doesn’t want to side with deadbeat homeowners could somehow twist the law to their preferences, but any objective reading shows a pretty open-and-shut case.

There are other devilishly clever aspects of this case that could compel the Governor to relent. First, it’s an election year. Second, the three groups suing, representing low-income African-Americans, Latinos and Asian-Americans, happen to be groups Democrats need to come out to the polls in November. (The African-American and Latino groups are faith coalitions, no less.) The case was filed in Sacramento, which should accelerate the hearings, perhaps as soon as this summer. It would be dicey to resist returning money owed to these communities and struggling homeowners in the middle of a re-election campaign. What’s more, this money remains necessary to help these communities right now; every day that goes by is another day someone fails to escape from foreclosure, and contrary to popular belief, here in California that crisis has not ended.

So this appears to be the right venue and the right situation to take a stand on behalf of homeowners who got screwed twice, first by financial institutions and then by their government. $350 million isn’t going to solve all the problems created by the housing crisis, but it says that, finally, there will be some accountability for this madness, and not everyone involved in this sad display will get away with the coordinated theft of ordinary Americans.

The complaint is really well-written (you can see Barofsky’s panache in there), so I recommend checking it out.