NEW YORK ( TheStreet) -- Richmond, Calif., earlier this week became the first city to use eminent domain laws to seize "underwater" mortgages and refinance them in an effort to prevent further foreclosures. The controversial move has little legal precedent and has the mortgage industry up in arms. "The program is ill-advised and likely unconstitutional and will add to Richmond's problems rather than solve them," David H. Stevens, president and CEO of the Mortgage Bankers Association, said in a statement Tuesday. 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. The law has mostly been used to seize property for public purposes such as building roads, highways or schools and other critical infrastructure. The municipality of Richmond is now testing whether the rule can be applied to seizing underwater mortgages from investors and banks. Richmond Mayor Gayle Mclaughlin has said that the city is using eminent domain to seize mortgages as a last resort, arguing that banks and servicers have shown little willingness to offer a solution to troubled borrowers in her city. Home prices in Richmond have recovered about 22% over the past year, according to Zillow, but are still 56% below their 2006 peak. More than half of the city's borrowers are underwater, according to officials, increasing the threat of more defaults and foreclosures. Foreclosures deeply depress property prices. Preventing them will improve the housing market and the local economy, benefiting the public, she argues. The city, partnering with San Francisco based Mortgage Resolution Partners (MRP), began sending letters to owners and servicers of 626 underwater mortgages this week. If the investors do not agree to sell at the negotiated price, the city will seize the property through eminent domain. As reported by The New York Times, the plan works something like this:"In a hypothetical example, a home mortgaged for $400,000 is now worth $200,000. The city plans to buy the loan for $160,000, or about 80 percent of the value of the home, a discount that factors in the risk of default.
Then, the city would write down the debt to $190,000 and allow the homeowner to refinance at the new amount, probably through a government program. The $30,000 difference goes to the city, the investors who put up the money to buy the loan, closing costs and M.R.P. The homeowner would go from owing twice what the home is worth to having $10,000 in equity." If the model is successful, it could be followed by other cities as well. Newark, N.J., Seattle and other cities in California are also considering the proposal, according to reports. Investors in mortgage-backed securities argue that seizing mortgages and forcing investors to take losses violates contract law and will have the effect of increasing the cost of mortgages for other borrowers as banks and investors factor in the risk of eminent domain. "The practical effect of this proposal will be that individual investors, who put their money into pension funds and other investment vehicles, making mortgage money available to homebuyers, will see their assets and savings arbitrarily, and we believe unconstitutionally, taken. This will not help expand mortgage credit availability in this country," said former Sen. Judd Gregg and CEO of SIFMA. Critics of the plan argued it will bring an onslaught of legal action from the industry. Mortgage Resolution Partners believe these threats are empty. On its Web site, it tackles the arguments against using eminent domain for seizing mortgages. "The proposal is entirely constitutional and will withstand any legal challenge," according to MRP. Banks are also unlikely to follow up on their threat to shun Redmond or other municipalities that adopt this plan. "The fact is that private lenders will always seek to earn profits from loans. They are currently shunning communities precisely because they expect the debt overhang to continue to drive home prices down. Communities that use eminent domain to clear out a dangerous inventory of underwater mortgages will be more attractive to lenders as a result, not less -- and will get there sooner than communities that do nothing." It also defended its role in the process. Critics have said that Mortgage Resolution Partners, a private company, stands to gain unfairly from the government's use of eminent domain. "MRP will earn a government approved flat fee per mortgage -- the same fee that any major bank earns today if it successfully modifies a loan under the federal government's Home Affordable Modification Program. MRP is not a venture capital firm and will not earn any profit share," it said.