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When Bad Things Happen to Good Cities
Are Lenders to Blame?
By Richard E. Gottlieb and Andrew J. McGuinness
They sound like names from a recent episode of The Daily Show or The O'Reilly Factor: Rudy Guiliani; Eliot Spitzer; the NAACP. But the topic is not the 2008 election, humiliating resignations, or civil rights. The year is 2003. The mayor of New York City, the attorney general of New York, and the NAACP are each pursuing lawsuits against the gun industry for the "dumping" of cheap guns in high-crime areas. The lawsuits are three of approximately 20 filed nationally claiming that the irresponsible marketing activities of gun manufacturers created a "public nuisance" in these cities, such that the manufacturers should be held financially accountable in damages.

Two of the three New York gun cases wound up in the Manhattan courtroom of federal judge Jack Weinstein. And while he eventually dismissed the NAACP lawsuit on standing grounds, the defendants could hardly claim victory. Judge Weinstein first held a six-week "advisory" jury trial in the NAACP case. Although the jury's findings were viewed by many as favoring defendants, in his 173-page opinion dismissing the case, Judge Weinstein stated: "The evidence presented at trial demonstrated that defendants are responsible for the creation of a public nuisance." The NAACP ruling was long seen as a blueprint for other cases against the gun industry. Judge Weinstein refused to dismiss the parallel lawsuit by New York City.

Other municipal suits had failed (Bridgeport, Philadelphia, Boston), but it took the passage of a federal statute in 2005 to kill the New York City gun case (and the Second Circuit in April 2008 reversed Judge Weinstein's refusal to do so). Municipalities have been no stranger to "public nuisance" litigation elsewhere, having employed the same legal theories to attack industries as diverse as tobacco and lead paint.

That was then; this is now. Ready for the next round? Today, the mortgage lending industry is the b┬Éte noire. As the wars in Iraq and Afghanistan head to the inside pages, newspaper headlines splash daily reports of Wall Street financial collapses, skyrocketing foreclosure rates, and plummeting home values. The economy—including those pesky real estate prices and the foreclosure crisis—threaten to displace our foreign wars as foremost in voters' minds this November.

Some cities are turning to the courts. After years of rising tax revenues driven by the real estate boom, cities across America are facing an epidemic of vacant homes as foreclosures skyrocket. Who is to blame for this devastation, these cities ask, and who should be held responsible for the increased costs of remediating the ensuing mess?

Baltimore. Buffalo. Cleveland. These cities and others have claimed that irresponsible lending practices by the mortgage industry and its backers have had the foreseeable result of blighting whole neighborhoods, leading to increased criminal activity in vacant homes and to declining property values (and therefore a diminished real estate tax base). Cleveland and Buffalo claim that the industry created a public nuisance. Baltimore claims that "predatory lending" by Wells Fargo, a leading mortgage lender, amounts to racial discrimination in violation of federal law.

There are important differences between the gun cases and the subprime mortgage cases, of course. For one, in the gun cases the defendants could point to criminal acts by third parties (the very criminals whose gun violence was the claimed public nuisance) as an intervening cause. The common law typically excuses a defendant for the intervening criminal acts of third parties.

But how different are these new cases? After all, most of society's ills are a foreseeable consequence of enabling products or services combined with human imperfection. People drive powerful cars too fast and wreak havoc. They drink too much alcohol and hurt themselves and others. Fast food restaurants, donut shops, and beverage manufacturers promote high-fat, high-sugar products that lead to obesity and the scourge of diabetes. It does not always take the intervening criminal act of a third party to insulate a defendant from liability. And sometimes the plaintiff—particularly when a stranger to the transaction—lacks a legally viable claim from the start.

This article surveys the circumstances, claims, and some likely defenses in this emerging area of municipal reform by litigation. Whether the cities will find a Judge Weinstein in the subprime mortgage cases or whether legislators will move to curtail this firestorm remains to be seen.

The Product

Of course, none of the current municipal subprime mortgage cases purport to hold lenders accountable for all foreclosures. Foreclosures have been a reality ever since there have been mortgages—they are an inherent aspect of lending secured by an interest in real property. So what is different now?

One of the cities, Baltimore, has marshaled some facially impressive data to attempt to sustain its burden of showing that something is meaningfully different—and wrong. In that city's complaint against Wells Fargo, Baltimore alleges that "[f]rom the first to the second quarter of 2007 foreclosure activity in the City increased five-fold." This complaint goes on to describe a national foreclosure rate in the third quarter of 2007 as "the highest rate of foreclosures in more than 35 years," and to cite a Joint Economic Committee of Congress prediction of nearly 2 million foreclosures nationwide on subprime mortgages from 2007 through 2009.

The cities argue that there is a qualitative difference to the wave of recent foreclosures, claiming that they result from "predatory" practices. While most (though not necessarily all) predatory lending practices involve subprime lending, not all (or even most) subprime lending can fairly be characterized as "predatory." Not surprisingly, subprime borrowers tend to be concentrated among more economically distressed segments of the population, notably, the urban poor. What is different, the cities say, is the quantity of money flowing into these communities in recent years on loan terms that are doomed to failure. The predictable result of these new lending patterns, they argue, are booming foreclosure rates and even greater community displacement, property devaluation, and social distress.

There is no consensus on what constitutes predatory lending, and even consumer advocates have recognized the benefits brought by subprime lending to the inner cities. While there may be no widely accepted definition of predatory lending, subprime lending is both easier to define and less controversial. Subprime mortgage lending typically refers to a loan to someone whose credit history is insufficient to qualify that borrower for a "prime" loan, such as a loan "conforming" to the underwriting guidelines of Fannie Mae and Freddie Mac. Poor credit history, including a spotty earnings history or a record of late and missed payments to creditors, or a recent bankruptcy, often account for a borrower being considered subprime.

Subprime Lending: Good or Evil?

The growth of the subprime mortgage market in recent years has been described by one source as follows:

Prior to the emergence of subprime lending, most mortgage lenders made only "prime" loans . . . Although borrowers with blemished credit might still represent a good mortgage risk at the right price, prime lending did not provide the necessary flexibility in price or loan terms to serve the borrowers . . . In the early 1990s, technological advances in automated underwriting . . . gave lenders the ability to adjust the price of loans to match the different risks presented by borrowers whose credit records did not meet prime standards . . . These subprime loans have allowed millions of borrowers to obtain mortgages, at marginally increased prices, even though their credit profiles do not qualify them for lower-cost prime loans. They have opened the door to homeownership to many people, especially low- to moderate-income and minority consumers, who otherwise would have been denied mortgages.

Interestingly, this rather favorable account comes from a plaintiff—Baltimore—in its subprime mortgage complaint against Wells Fargo Bank. Mayor and City Council of Baltimore v. Wells Fargo Bank, N.A. et al.

This homage to subprime lending is emblematic of the thin line cities are walking in this arena. For years cities have pushed for banks to increase mortgage lending to urban residents of modest means. They were asking, in other words, for more subprime mortgage lending to their residents, thereby "open[ing] the door to homeownership to many people, especially low- to moderate-income and minority consumers, who otherwise would have been denied mortgages," as Baltimore says. But by their very nature subprime mortgages face a greater risk of foreclosure, and are priced accordingly. By "priced accordingly," we mean that banks charged higher interest rates and fees (each of which tend to increase a loan's profitability) to offset the greater risk of default that could lead to a home loan becoming unprofitable indeed.

A Paradox Wrapped in a Paradox

One of the central contradictions of these cases is that banks are essentially being sued for making credit available to high-risk inner-city borrowers, thereby allowing numerous otherwise underserved consumers to achieve or maintain the American dream of home ownership. Another, related, paradox is that essential market-based features of these riskier loans that allowed them to materialize—higher fees and interest rates to compensate for the increased risk of default—themselves increased their cost by making the loans less "affordable" and thereby more likely to result in such default.

The city lawsuits focus more on the effects, that is, foreclosures and abandoned homes. They point to these foreclosures and ask the court (or jury) to conclude—based largely on the fact of the foreclosures themselves—that the banks acted improperly, even "unscrupulously" and "irresponsibly." The irony is that no bank wants a foreclosure. A foreclosure represents a failed loan and, typically, huge bank losses. This is even more manifestly the case when the foreclosed property remains vacant (the alleged public nuisance). Every vacant home resulting from a foreclosure that a city claims is blighting its neighborhoods represents not just a bad loan but an unsuccessful foreclosure as well. Are the cities pointing at these manifestations of failed loans and demanding one more ounce of flesh from a reeling industry? Or are these vacant homes the most conspicuous examples of irresponsible lending?

A Tale of Two Cities

The municipal subprime mortgage lawsuits are not all the same. Compare the Baltimore and Cleveland lawsuits.

Baltimore's lawsuit is targeted against a single lender, Wells Fargo. The Baltimore case is not a public nuisance action, but rather a one-count racial discrimination claim under the federal Fair Housing Act of 1968. The complaint alleges that Wells Fargo engaged in "reverse redlining":

In contrast to "redlining," which involves denying prime credit to specific geographic areas because of the racial or ethnic composition of the area, reverse redlining involves the targeting of an area for the marketing of deceptive, predatory or otherwise unfair lending practices because of the race or ethnicity of the area's residents.

The Baltimore case is a "disparate impact" case. That is, it attempts to prove racial discrimination by allegations such as:

In 2005 and 2006 . . . two thirds of Wells Fargo's foreclosures were in Baltimore City census tracts that are more than 60% African-American, while only 15.6% were in tracts that are less than 20% African-American. Wells Fargo's foreclosure rate for loans in African-American neighborhoods is nearly double the overall City average, while the rate for its loans in white neighborhoods is less than half of the average.

Baltimore seeks to recover the city's damages (not those of borrowers), injunctive relief, attorney fees, and punitive damages. The city's complaint describes Wells Fargo as the largest mortgage lender in the city. What are the damages to the city? According to Baltimore's complaint:

Foreclosures in [economically distressed] neighborhoods frequently lead to abandoned and vacant homes . . . Concentrated vacancies driven by foreclosures cause neighborhoods, especially ones already struggling, to decline rapidly . . . [F]oreclosures are responsible for the loss of hundreds of millions of dollars in the value of homes. This, in turn, reduces the City's revenue from property taxes. It also makes it harder for the City to borrow funds because the value of the property tax base is used to qualify for loans.

The complaint goes on to list lost revenue from transfer taxes (since foreclosures allegedly depress the local housing market), costs of administrative hearings relating to foreclosures, costs of securing vacant homes, and additional police and fire services (not quantified) "as vacant properties become centers of dangerous and illicit activities."

City of Cleveland v. Deutsche Bank Trust Co., et al., filed just days after the Baltimore suit, claims similar damages but is otherwise quite different. Like the gun cases, its central claim is one of "public nuisance," not discrimination. It is not against a single, predominant lender but against an entire industry—frequently referred to as "Wall Street" in the complaint. (Gordon Gekko is apparently alive and well.) And, notably, Cleveland's lawyers almost entirely eschew use of the phrase "predatory lending," instead launching an attack on the subprime mortgage industry at large. Not lacking in ambition, the complaint asserts that "[r]esponsibility for Cleveland's plight rests principally with sub-prime's so-called 'securitizers'—investment banking firms from Wall Street and elsewhere that actually provided the cash used to make loans, regardless of the lender or broker nominally involved in the transactions." Cleveland bemoans the "astronomical fees" and the "voracious" "appetite" of the mortgage-backed security industry.

In essence, Cleveland's complaint attempts to hold investment banks liable for creating a market for the loans—many of which may have been ill-advised in retrospect—even though these investment banks would likely have had no dealings with borrowers themselves. And the inner-city brokers who did have direct contact are absent from the complaint, as are the Ohio-based lenders, leading some to suspect that the city's motivations were political. In so many words, Cleveland accuses out-of-state investment banks of shoving money at the originators and thereby fostering their misdeeds, a practice it labels "the phenomenon of money seeking borrowers."

Both complaints articulate particular practices, but often in conclusory terms. "Failing to prudently underwrite," extending mortgage loans on terms that the borrower "could not afford," and "failing" to underwrite loans based on "traditional underwriting criteria" are included in the Baltimore complaint. But are these simply pejorative descriptions of the same features of subprime loans that the city acknowledges provided the "necessary flexibility" that prime lending practices lacked, and that "open[ed] the doors of homeownership to millions"? And do the cities' allegations of improper subprime lending amount to a tautology: If a loan defaults and the bank is forced to foreclose, then the underwriting was ipso facto "imprudent" or "irresponsible" and the loan it generated "unaffordable." But what about the millions of loans based on the same underwriting and with the same terms that have not defaulted? Were they prudently underwritten, responsible, and affordable? And how were lenders supposed to know ahead of time which would be which?

The defense in the Baltimore case will be fact-based, disputing the inferences that can be drawn from the subprime lending and foreclosure patterns in that city, as well as the predatory nature of the practices involved. Federal preemption based on compliance with federal banking regulations is another defense, as is unclean hands.

The City's . . . own tax lien sales . . . have resulted in over 19,000 foreclosure actions being filed against City homeowners during this same seven-year period . . . The City places liens on homes for any type of unpaid municipal bill over $100, and then sells the liens to private investors, knowing the investors will threaten to foreclose on the homes unless the homeowners agree to pay exorbitant fees . . . The City's tax lien sales, moreover, have disproportionately injured minority homeowners in the City's poorest neighborhoods. Over half of the 2006 tax lien sales based only on small unpaid water bills or municipal fees involved properties in census tracts that are more than 80% African-American and over two-thirds involved properties in tracts that are over 60% African-American, but fewer than 11% involved properties in tracts that are 20% or less African-American. (Wells Fargo motion to dismiss, March 2008.)

The defenses in the Cleveland case are different, with other legal and policy issues at play. Like the gun cases, Cleveland's public nuisance claim raises issues of standing, of whether or not there is a "public right" (as opposed to an individual right) to be free from unfair or predatory lending practices, of whether the type of detriment alleged by that city constitutes an "unreasonable interference" that has an ongoing and "significant effect" on a public right, of whether defendants' conduct is the proximate cause of the city's ills, and of whether the city has alleged cognizable damages.

The "public right" issue is a thorny one. Faced with this question, the Illinois Supreme Court in the gun case worried that if it recognized a public right to be safe, then the alcohol industry might be sued for public nuisance because of the illegal acts of drunk drivers. City of Chicago v. Beretta U.S.A. Corp., 213 Ill. 2d 351, 375 (Ill. 2004). Also, what right does the government have to require the owner of real property to occupy it (or have it occupied)? On the question of unreasonable interference, the Cleveland defendants will likely point to the fact that their product (subprime loans) is legal and that they complied with all applicable regulations.

More Questions Than Answers?

These lawsuits beg a multitude of questions. What is an acceptable rate of foreclosure in residential mortgages? Two percent? Four percent? More? Who decides? The courts? Based on what criteria? On whether such foreclosures impact minority urban communities disproportionately as compared with predominately white communities? If so, should banks restrict riskier forms of subprime lending to areas other than minorities? Would not that practice also be deemed discriminatory?

Nobody wants foreclosures. The lenders rarely recoup anything close to their investment, and the borrowers lose their homes. But what do urban residents of modest means and "blemished" credit want up front? Do they want access to subprime debt? If the cities are successful in their lawsuits, are credit-impaired residents likely to get such access?

From a jurisprudential perspective, how likely would it be for any judicial process, particularly one involving a jury, to delineate precise contours of acceptable versus "irresponsible" lending practices? After all, it takes courts years to pin down just what constitutes legal and illegal lending practices under even detailed statutory schemes such as the Equal Credit Opportunity Act and the Truth in Lending Act. And what kind of rate premiums will the aggressive, non-risk-averse lenders willing to enter such murky waters charge?

In short, if successful, these lawsuits may ultimately do more long-term harm than good. The cities hope to reap hundreds of millions of dollars from the banks to reimburse them for a diminished real estate tax base resulting from foreclosures. But lenders should logically be entitled to an offset for the higher tax revenues collected by cities for years that, according to the logic implicit in their complaints, were associated with the now-challenged lending practices. And if banks stop making loans in urban areas to avoid exposure, the property tax base in these inner cities will be devastated. And how will poorer city residents buy houses then?

Even assuming that one could confidently discern with hindsight which loans, viewed prospectively, involved improper conduct, it may be difficult for anyone to reliably determine how any resulting foreclosure affected property values in a given neighborhood, much less the tax base of the city going forward. Land values are complex phenomena, responding to broad economic factors and regional elements. It would be a largely Sisyphean task to isolate the contribution of foreclosures solely related to improper loans from all other factors.

The Courts as Social Engineers

A decade before the civil rights laws of the mid-1960s, the Supreme Court in 1954 decided Brown v. Board of Education of Topeka and put teeth in the constitutional concept of racial equality. While the Court was responding to significant ongoing social currents, it led at a time and in an area when and where legislatures were unable or unwilling to lead.

It is difficult to extend that paradigm to the subprime mortgage arena. While it is not difficult to believe that foreclosures—particularly those in areas where empty houses tend to remain vacant—have a negative effect on the community, there is little reason to believe that the lenders are not already paying a steep price (lost principal, diminishing collateral, hundreds of millions of dollars in write-downs). And unlike with segregated schools, there is little reason to suspect that legislatures are unwilling or unable to act out of constitutionally suspect bias or racism. On the contrary, dozens of new laws and regulations have been instituted since this crisis came to the fore, and more are enacted on an almost daily basis by federal and state governments.

Rather than seeking to hold lenders liable in damages for bad subprime loans, if constitutional measures can be found to abate future foreclosures, that is likely to be far more productive. So far this effort is centered in legislatures, where the complex balance between attracting capital to poor neighborhoods while protecting their residents stands a better prospect of success.

Pre-Mortem?

While it is too soon to say how the municipal subprime mortgage lawsuits will turn out, the Illinois Supreme Court's disposition of the Chicago gun case seems apropos:

Plaintiffs and the amici supporting their position advocate expansion of the common law of public nuisance to encompass their novel claim . . .

To do so, we would have to decide each of the issues raised in this appeal in plaintiffs' favor. In effect, we would have had to resolve every "close call" in favor of creating an entirely new species of public nuisance liability. Instead, after careful consideration, we conclude that plaintiffs have not stated a claim for public nuisance. Even granting, arguendo, that a public right has been infringed, we conclude that their assertions of negligent conduct are not supported by any recognized duty on the part of the manufacturer and distributor defendants and that . . . their allegations of intentional conduct are insufficient for public nuisance liability as a matter of law . . .

Any change of this magnitude in the law affecting a highly regulated industry must be the work of the legislature, brought about by the political process, not the work of the courts. In response to the suggestion of amici that we are abdicating our responsibility to declare the common law, we point to the virtue of judicial restraint.

Whether the judiciary will ultimately choose to exercise such restraint in the lender "public nuisance" cases is an open question.

Buffalo's Spin

Contrast the Baltimore and Cleveland cases with a more recent case brought by the City of Buffalo against 36 financial institutions seeking reimbursement of demolition costs and other damages relating to 57 distressed properties. City of Buffalo v. ABN Amro Mortgage Group, Inc., et al., State of New York, Supreme Court, Erie County (filed February 20, 2008). That case is not expressly a predatory lending case on its face, since it does not contain specific allegations regarding any improper lending practices. However, it does assert a "public nuisance" as well as purported violations of city ordinances governing the disposition of such properties. Further, the city follows Cleveland's lead by referencing the 3,000 foreclosure filings in Buffalo in the past two years, and the 10,000 vacant properties in the city. Moreover, it seeks to recover against defendants "jointly and severally" for the costs of abatement, including demolition at an average cost of $16,000 per dwelling. Whether considered a subprime mortgage case or not, one could read the new Buffalo strategy not only as a way to put pressure on mortgagees to think twice about foreclosing on real estate in that city, but also as a clever tactic to use city ordinances as a profit center.

Further Reading

For a thorough discussion of the municipal standing issue in predatory lending litigation, see Jonathan L. Entin & Shadya Y. Yazback, City Governments and Predatory Lending, 34 FORDHAM URB. L. J. 757 (2007). Perhaps not coincidentally, the authors are both from Cleveland.
Gottlieb directs the financial institutions practice at Dykema Gossett PLLC. McGuinness leads the firm's class action defense practice. They can be reached at rgottlieb@dykema.com and amcguinness@dykema.com. Dykema Gossett PLLC represents lenders in both the Buffalo and Cleveland lawsuits referenced in this article. The views expressed herein are those of the authors and are not intended to represent the views of the firm or its clients.

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