California City Moves Ahead With Eminent Domain Mortgage Plan Despite Risks (Update 1)

Updated from 11:11 a.m. ET with comments from SIFMA.

NEW YORK ( TheStreet) -- The city council of Richmond, Calif. has voted in favor of moving ahead with a proposal to seize underwater mortgages from bond investors through eminent domain, despite the likelihood of a long legal battle.

The council voted 4-3 in favor of the "Richmond CARES" program, under which the city, in partnership with a firm called Mortgage Resolution Partners, seeks to buy 624 underwater mortgages held by private investors at a discount to the underlying property value, write them down and refinance them. If investors do not voluntarily sell, the city will seize it through eminent domain.

Still, there were clearly concerns among some officials that the plan came with considerable risks. The mortgage industry, including the Federal Housing Finance Agency which regulates Fannie Mae and Freddie Mac, has threatened to cut off Richmond if it uses eminent domain to seize mortgages.

Recently, the city had trouble finding takers for a municipal bond offering in August.

And the legal battle could be lengthy and costly for the city, with eminent domain cases typically taking two years in court and appeals taking even longer.

"A 1 percent chance of bankruptcy from this program is a deal-breaker for me," Councilman Jim Rogers said at the city council meeting, according to Reuters.

Eminent domain allows government to seize private property for public use for fair compensation.

Richmond officials argue it is the only way they can prevent further foreclosures in the city where more than half of the borrowers owe more than their mortgages are worth and are arguably at risk of default.

The mortgage industry has promised a fierce fight, arguing the proposal is unconstitutional and ill-advised, especially because many of the 624 mortgages that the city plans to write down are current and the offer from Richmond is well below what the investors consider to be the fair market value of the loan. Moreover, nearly 40% of those loans have already been modified.

Critics say the plan does not really benefit the public and that Mortgage Resolution Partners, which earns a fee for every mortgage refinanced under the program, stands to unfairly profit at the expense of bond investors.

Investors have already sued through trustees Wells Fargo and Deutsche Bank in U.S. District Court to block the plan.

Several cities are considering the proposal, but some have already backed down fearing the backlash. Last week, the city of North Las Vegas, Nevada rejected the eminent domain proposal. Last year, California's San Bernadino county also abandoned the proposal.

Richmond will be the first to proceed with the plan on the urging of Mayor Gayle McLaughlin, who has dismissed threats from the mortgage industry. Cutting off the city from access to credit or raising borrowing costs would be in violation of fair lending practices as the city has a large minority population, she argues.

"This is a great victory in the process for my family and the City of Richmond. We can now look forward to the next step of the process with high expectations for the final result, principal reduction," said ACCE Home Defenders League member Morris LeGrande, one of the leaders of the community organizing effort and whose own Richmond home loan is deeply underwater. "Being first in anything is a painful experience. Fighting for civil rights was a painful experience, but the end result was equal rights for all American citizens. The same type of sacrifice is being made by taking on Wall Street."

LeGrande is one of Richmond's many underwater borrowers. His loan was modified in 2009, but he says he still won't be able to make the monthly $3,000 payment, according to this story from Bloomberg.

Richmond plans on partnering with other local governments still contemplating the proposal.

Securities industry lobby group SIFMA said the city's decision to move ahead with the proposal would do more harm than good. "The City is moving towards a massive potential liability for which it cannot be fully indemnified, according to the proponents of the eminent domain plan, putting Richmond's residents and taxpayers at significant risk," it said in a statement.

-- Written by Shanthi Bharatwaj 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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