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Eminent Domain Plan to Seize Underwater Mortgages Could Sink City

Stocks in this article: FNMA FMCC WFC BLK

But the value of a current mortgage loan, investors argue, is not based on the value of the underlying collateral. It is based on the present value of future cash flows.

What's more, the city plans to refinance the mortgage loan in the example at $190,000, giving borrowers $10,000 worth of equity in the deal. The spread would help pay the city's costs and MRP's fees, with enough left to give the new investors in the refinanced mortgages a tidy profit.

But the very fact that these mortgages can be refinanced at a higher rate suggests that Richmond is not buying at fair market value, because investors buying these loans should not be able to make a profit on purchase.

The economics of the proposal for Richmond hinges on the borrowers being current, as investors will clearly not refinance a loan to a borrower who has defaulted. It also crucially depends upon the mortgage loan being bought at a steep discount for it to be profitable to investors.

"There are a lot of assumptions in this plan that just won't work," says Edward Burg, partner at law firm Manatt, Phelps & Phillips. Burg regularly represents property owners in eminent domain cases in California. "They are taking way too much risk for too few benefits. This is an uncertain area."

Burg says the proponents of the plan ignore the fact that most borrowers who are under water on their mortgage continue to pay their loans because they simply have to. They need housing and rents are rising sharply. Walking away from a mortgage is easier said than done.

Also, he argues, the economic proposal won't work if the compensation turns out to be higher than what is proposed on the plan. "Broadly speaking, the jury tends to trend closer to the property owner. In the larger cases that I have tried, the property owner got 70% of the spread difference between the values estimated by the owner and the government . When the idea of what the mortgage is worth is so far apart, even if they split the difference, Richmond and its investors won't make money."

The city is also underestimating the legal fees they could end up paying. According to Burg, MRP estimates $1,950 in legal fees per eminent domain case. This is ridiculously low, considering the average eminent domain case in today's underfunded Californian courts is two years, with an appeal adding another two years to the timetable.

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