San Bernardino County is forging ahead with deliberations on a proposal to seize underwater mortgages, despite its largest city's decision Tuesday night to seek bankruptcy.

The California city is not directly involved in the proposal, but industry members say its bankruptcy could interrupt funding and create other hurdles for the county and its partners.

San Bernardino County, which is considering a plan to use eminent domain to restructure underwater mortgages, is still planning to host its first meeting to discuss mortgage modification proposals on Friday, spokesman David Wert said on Wednesday. The proposal has raised the ire of investors in private-label mortgage-backed securities, who could face significant losses if the loans are seized.

The county recently joined forces with two of its cities, Fontana and Ontario, to form the Homeownership Protection Program Joint Powers Authority, which would be empowered to use eminent domain for the modifications if the county decides to go forward with the plan.

The city of San Bernardino is not currently part of the JPA, and Wert downplayed the influence of the potential bankruptcy on the county's eminent domain proposal.

"The City of San Bernardino bankruptcy issue would have no impact on the JPA, primarily because the City is not a member of the JPA. The JPA's only members at this point are the County of San Bernardino and the cities of Fontana and Ontario," he said in an email. "But even if the City of San Bernardino were to join the JPA, the bankruptcy issue wouldn't come into play because no public funds would be involved in any of the proposals to be considered by the JPA."

However, lawyers argue that the city's bankruptcy could indeed have an impact on how the county and its partners would finance the proposal. The plan to invoke eminent domain was initially proposed by Mortgage Resolution Partners, a San Francisco venture capital firm that will partner with municipalities to purchase and modify the loans. The firm has hired investment banks Evercore Partners and Westwood Capital to raise funds from private investors that would be used by the San Bernardino County government to purchase the loans.

"The bankruptcy wouldn't stop that plan from going forward," says Karol Denniston, a partner at Schiff Hardin. "But what it may do is make the fundraising for the whole project much more difficult."

"If a major city is in bankruptcy, that's going to have a knock-on effect on credit ratings," making investors warier and fundraising more expensive, Denniston adds. "It has its ability to work its way up the food chain, in terms of the market reactions."

Part of that investor concern could stem from fears of contagion, the notion that one bankruptcy filing could trigger a domino effect.

"The notion is, if one municipality does it, will others do it? If there's an unwillingness to pay or to live up to your obligation, will that bad act be followed by others?" says James Spiotto, a partner at Chapman and Cutler.

A spokesperson for Mortgage Resolution Partners referred questions to the county.

San Bernardino County's eminent domain authority is restricted to the jurisdictions that are member agencies of the JPA, currently just the cities of Fontana and Ontario and unincorporated areas of the county, according to Wert.

But if the city of San Bernardino were to join the JPA down the line, it could also potentially hamper the city's efforts to revive its desperately-needed revenue, says Michael Sweet, a partner at Fox Rothschild. Depending on how the modifications are conducted, they could potentially trigger property value reassessments down to the fair market values of the homes, thus reducing the amount of taxes the city could collect on the properties.

"The problem that San Bernardino and other cities have has to do with insufficient revenue to cover expenses …and most of that revenue is property-tax driven," Sweet says.

"If the plan cuts the underlying value of the real estate in the city …that would further reduce revenue, because it cuts the amount of property tax the City will be collecting."

For now, much about the mortgage modification plan is still up in the air.

Wert told American Banker last week that the county is exploring the option of using eminent domain to obtain underwater mortgages and restructure the loans, but that it had not made a final decision on the plan.

The meeting on Friday will be "strictly organizational in nature" and "there will be no discussion on any of the various homeownership protection program proposals the JPA will eventually examine," according to a meeting announcement.

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Corrected July 17, 2012 at 3:32PM: Clarification: An earlier version of this story incorrectly said the proposal relates to delinquent mortgages. It relates to underwater mortgages, in which the borrower is "relatively current (not in default)" on payments but owes more than the home is worth.