Eminent Domain Plan to Seize Underwater Mortgages Could Sink City

NEW YORK ( TheStreet) -- Richmond, Calif. Mayor Gayle Mclaughlin is determined to go ahead with the city's plan to seize underwater mortgage loans from investors using its right of eminent domain.

But the creative plan is ill-advised, according to legal experts. The proposal has a long shot at success in court and has serious repercussions for the City of Richmond.

Major investors holding the mortgage loans in question, including housing giants Fannie Mae ( FNMA) and Freddie Mac ( FMCC) and the likes of Blackrock ( BLK) and Pimco, have challenged the constitutionality of the proposal, asking a federal court to stop the city from moving forward.

Federal agencies including the Federal Housing Finance Agency, regulator of Fannie and Freddie, and the Federal Housing Administration, have also raised concerns about the proposal. The FHFA has said it would consider directing the GSEs to restrict or cease activities in communities employing eminent domain to "restructure mortgage contracts," in order to protect its interests.

This could hurt the ability of Richmond homebuyers to secure loans.

The FHA has also expressed concerns about the use of eminent domain and does not know whether it will insure new mortgages in Richmond, pending legal developments and further execution of the plans in question. If the FHA does not back the proposal, it could be a major blow to the eminent domain plan, as the city intends to write down the loans seized from investors and then refinance them through a government-sponsored program such as those offered by FHA.

Investors have rejected the city's offer to "voluntarily" sell mortgages at a discount to current property values. Banks including Wells Fargo ( WFC) have said that loan servicers and trustees are contractually prevented from selling individual loans out of mortgage-backed security trusts.

It should come as no surprise that the proposal has the mortgage industry up in arms, as eminent domain overrides contract law.

Richmond's Mayor believes banks have caused the residential real estate crisis and should fix it, and if they don't, the city will take matters into its own hands.

But the current owners of these mortgage loans aren't banks. They are pension funds and insurers.

The main source of contention here is not constitutionality really, but the fact that a majority of the mortgage loans in question are current. That is, despite the fact that borrowers have been under water, they continue to make their loan payments.

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