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Eminent Domain Plan to Seize Underwater Mortgages Could Sink City

Stocks in this article: FNMA FMCC WFC BLK

Richmond, along with Mortgage Resolution Partners (MRP), the main proponent of the proposal, argues that underwater mortgages are most at risk of default and hence writing down principal and refinancing these loans is the best way to prevent foreclosures.

But these are borrowers who have been under water for five years. Investors argue there is nothing to suggest that they will start defaulting now when the economy is improving and property prices are rising. Home prices in Richmond have risen more than 20% over the past year, according to Zillow.

Mortgage analysts point out that about 40% of the 624 loans that Richmond plans to buy or seize have already received a modification. The Wall Street Journal reports that at least three loans have a mortgage balance of over $880,000 suggesting that these homes were likely million-dollar homes at the market peak.

"The loans were appraised by an independent, third party valuation expert, whose appraisal takes into consideration the likelihood of default and the loss given default," said John Vlahopolus, a founder of MRP, in an email to TheStreet. "The appraisal of the fair values of the loans reflects these independent judgments. Many of the loans have received modifications, and the independent appraisal takes those modifications into account. Modifications like these have shown a high likelihood to re-default because they still leave the homeowner deeply underwater."

But even if Richmond successfully argues that there is a public benefit in seizing these mortgage loans -- courts have over time interpreted the definition of public use fairly loosely -- they will still likely fight a prolonged legal battle with investors over compensation.

Eminent domain allows the state to seize private property for public use for a "reasonable compensation" or fair market value, determined by court.

Richmond and MRP say fair market value of a mortgage loan that is worth, say, $300,000 on a home currently worth say, $200,000, is actually just $160,000. The discount to the property value, they argue, is necessary because of the chance of default. Essentially, they are expecting investors in this example to swallow a loss of nearly 50% on a current mortgage.

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