) --

Freddie Mac


said it would consider suing the city of Richmond, Calif. if it chooses to use eminent domain laws to seize mortgages of underwater borrowers and modify them in an effort to prevent more foreclosures.

Eminent domain is the power of the state to seize private property for public use or benefit. The owner is typically entitled to reasonable compensation, referred to as fair market value.

Richmond recently became the first city to test whether the laws could be used to seize mortgages. The city plans to buy mortgages at "fair market value" or, if investors do not sell at the negotiated price, seize them through eminent domain for a compensation to be determined by court.

Richmond officials argue that modifying loans would prevent further defaults, prevent foreclosures and ultimately raise property values in the city.

Still, the use of the law to seize mortgages has little legal precedent and has the

industry up in arms


"Our sense is that so-called voluntary loan sales would not be very voluntary. They are loan sales under pressure in fact, under a threat of seizure by eminent domain. We would consider taking legal action," William McDavid, general counsel of Freddie Mac, on a conference call with reporters Wednesday, according to



The Federal Housing Finance Agency, regulator of

Fannie Mae


and Freddie Mac, has previously voiced concerns over the use of eminent domain.

The agencies are big buyers of private-label mortgage-backed securities.

While critics of the proposal say the use of eminent domain to seize mortgages is likely unconstitutional, legal experts say the city may be within its rights in doing so. But that does not mean it won't have a

legal battle

on its hands.

Compensation for the mortgages are determined by the courts and it is very likely that investors will challenge the city on its valuation of the mortgage. The city wants to buy the loan at a discount to the current value of the property.

Investors owning an underwater mortgage that is still current will likely want to be paid in full. So expect a fight over pricing for every loan.

Cities might find that they might have to pay more for a mortgage and it isn't clear if the economics of the proposal would work under those circumstances.

Meanwhile, investors have said they would tighten underwriting or charge higher rates in communities that threaten to use eminent domain to seize loans.

For cities still struggling to get back above water, however, this is a daring proposal that might just work.

-- Written by Shanthi Bharatwaj New York.

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