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Mortgage Bond Investors Sue City Over 'Brazen' Eminent Domain Proposal (Update 1)

Updated from 9:56 a.m. ET with statement from Federal Housing Finance Agency, the regulator of Fannie Mae and Freddie Mac.

NEW YORK ( TheStreet) -- Mortgage bond investors including Blackrock (BLK - Get Report) and Pimco are suing the city of Richmond, Calif. over its recent action to seize mortgage assets throughout the U.S. by using its power of eminent domain.

Eminent domain gives the government the right to take private property for public use for fair compensation.

The city of Richmond is applying the law to mortgages, an action which has little legal precedent.

The city, in partnership with Mortgage Resolution Partners, a major advocate of the proposal, plans to buy mortgages at a discount to current property value and then refinance them at lower rates. Borrowers will see their monthly payment sharply lower and will also have some equity in their home, which will give them an incentive to stay current on their loans.

Richmond argues that this will lower the risk of future defaults and foreclosures and benefit the local economy. Mayor Gayle McLaughlin described it as a last resort to save borrowers, as investors and servicers of non-government-owned mortgages have been reluctant or slow to modify mortgages.

The mortgage industry argues that the use of eminent domain to seize mortgages is unfair as it benefits borrowers at the expense of investors and that it is likely unconstitutional.

On Tuesday, the Association of Institutional Investors said it has directed trustees of residential mortgage-backed securities to file a legal complaint requesting an injunction in Court to preempt the city's actions.

"This inappropriate use of a municipality's public power of local eminent domain to seize interstate assets for private gain will create immediate harm to public pension plans and retirement systems throughout the United States and could hurt the ability of ordinary Americans to obtain cost-effective mortgage loans in the future" said Rosemary Becchi, a spokesperson for the Association.

Richmond officials did not respond to a request for comment.

Mortgage Resolution Partners was also the target of much of the complaint.

"Mortgage Resolution Partners is threatening to seriously harm average Americans, including public pension members, other retirees and individual savers through a brazen scheme to abuse government powers for its own profit," said John Ertman, Partner at Ropes & Gray LLP on behalf of the group of institutional investors that directed the legal action. "This unconstitutional application of eminent domain will be devastating for mortgage finance both public and private. It will completely undermine the willingness for private capital to return to the mortgage markets."

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