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) 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."
"Mortgage Resolution Partners has reviewed the lawsuit and is confident that it is without merit,"said Steve Gluckstern, the firm's Chairman in a statement. "The actions of the City of Richmond and MRP are entirely within the law, and any loan purchase will be at fair value. No investor in any trust will be made worse off by the sale of any loan. Rather, it is these trustees that are wasting trust assets at the expense of America's pensioners by pursuing fruitless litigation." Mortgage Resolution Partners on its website denies it is a venture capital firm and describes itself as a "Community Advisory" firm. It says it gets a government-approved flat fee for its role in assisting cities such as Richmond in using their power of eminent domain to modify mortgages. Housing giant Freddie Mac ( FMCC) also said yesterday that it would consider legal action if Richmond goes ahead with the proposal. Fannie Mae ( FNMA) CEO Tim Mayopoulos said during its media call following earnings Wednesday that it believed the use of eminent domain to seize mortgage assets was an "inappropriate use of that power" and that it had joined a coalition of investors in those securities Richmond plans to seize. The group plans to take legal action to protect its investors. He said the proposal, if implemented, "has the potential to unsettle investors in mortgage assets." The Federal Housing Finance Agency also said Thursday that it had "serious concerns" about the use of eminent domain to restructure residential mortgage contracts. The regulator said it would legally challenge any local or state action that sanctions the use of eminent domain. It will also consider using its authority to "direct the regulated entities to limit, restrict or cease business activities within the jurisdiction of any state or local authority employing eminent domain to restructure mortgage loan contracts; or take such other actions as may be appropriate to respond to market uncertainty or increased costs created by any movement to put in place such programs." Investors have said that the use of eminent domain to seize mortgages will decrease the availability of credit. Supporters of the plan have dismissed it as empty threats, but it looks like the FHFA will carry it through. -- Written by Shanthi Bharatwaj in New York.