There is no provision that stops borrowers from making payments during that time, which means borrowers don't really get help in this time period.

And if the city decides to abandon the case, it is responsible for the lender's attorney fees.

Burg cites an example of the city of Oakland, Calif trying to acquire the Oakland Raiders professional football team when it was decided to move the franchise to Los Angeles. The city lost and ended up paying $3.2 million in legal fees to the Raiders' attorneys. It also entered into a $4 million settlement with the football team which had demanded $26 million in damages because the city had blocked its move to L.A. and deprived it of revenue.

Add to this the very real threat that banks could curtail credit to Richmond and you see how the risks add up. The proponents of the proposal say this is an empty threat, because banks will be violating fair lending rules.

But actually investors in mortgage-backed securities take into account state foreclosure laws and other rules that increase the cost of lending all the time. Fannie and Freddie for instance have proposed raising guarantee fees in states that have an unduly long judicial foreclosure process.

If investors believe there is a risk that a city would seize mortgage loans because the borrowers are under water, they have the right to shun loans originated in those communities. And poor demand from the secondary market will have the effect of curtailing credit in these areas.

At best, the proposal smacks of desperation, as Richmond officials are trying to find ways to revive housing and the local economy.

"The government, encouraged by a private entity MRP , is trying to solve this problem. But this isn't the way it can solve it," says Burg.

-- Written by Shanthi Bharatwaj in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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