A proposal by San Bernardino County to use eminent domain to seize, and then restructure, underwater private-label mortgages would result in more than just losses to private investors. Fannie Mae, Freddie Mac and the Federal Home Loan Banks are also major investors in private-label securities and they too would suffer if the county took over what is estimated to be 150,000 underwater mortgages.

The losses to the government-sponsored enterprises would likely be minimal — particularly in comparison to the more than $160 billion in losses so far to taxpayers. But the concern is that the use of eminent domain powers by municipalities would set a precedent, throwing a wrench in the Obama administration's long-term plans to reduce the government's role in housing by turning as much as possible over to the private sector.

"There are huge unforeseen problems that would occur from eminent domain that could blow up private mortgage lending," says Scott Simon, a managing director at bond giant Pimco and the head of its mortgage-backed securities team.

If the proposal to use eminent domain to restructure underwater mortgages moves forward, the Federal Housing Finance Agency likely would sue San Bernardino County for encroaching on its role as Fannie and Freddie's sole regulator, mortgage experts and bondholders say.

Corinne Russell, a spokeswoman for FHFA, says the agency "has concerns with this use of eminent domain and is communicating with county officials to better understand their intentions for such a program."

The agency has been quick to cite the Housing and Economic Recovery Act of 2008, which stipulates that while acting as conservator, FHFA "is not subject to the supervision or direction of any other agency."

In December, FHFA sued the city of Chicago to prevent it from enforcing a vacant buildings ordinance that sought fines and penalties of up to $1,000 per day.

It's unclear how much of the GSEs' holdings are invested private-label securities in San Bernardino. Fannie held $71 billion in private-label mortgage-backed securities at the end of May, while Freddie held $135.5 billion, according to the GSEs' monthly summary reports.

The 12 Federal Home Loan Banks held $17 billion in such securities, according to their first quarter combined financial report. The figures represent the unpaid principal balances of non-agency holdings.

San Bernardino County caused a ruckus with bond investors when it created a Joint Exercise Powers Authority last month in agreement with the cities of Fontana and Ontario to devise a Homeownership Protection Plan. Eminent domain is one of the proposals being considered to aid underwater borrowers.

Tom Deutsch, executive director of the American Securitization Forum, a trade group for bond investors, says the same thing that happened with Chicago could happen with San Bernardino because FHFA is required to preserve the assets of the government-sponsored enterprises for the benefit of taxpayers.

"States and localities can't interfere with that," Deutsch says.

No lawsuits have been filed yet because the San Bernardino proposal is still in the early stages, but the private investors are rooting for the FHA to take action because it would have the best shot of prevailing in court, experts say.

Still, Deutsch's group has retained the law firm Sidley Austin LLP and the securitization industry is clearly girding for what could be a protracted legal fight. Carter G. Phillips, a managing partner at Sidley Austin, has argued more cases before the Supreme Court than any lawyer currently in private practice.

Investors are particularly miffed that the San Francisco venture capital firm Mortgage Resolution Partners, which had pitched the eminent domain proposal to several California cities, singled out performing but underwater loans in private-label securities, in which the borrower is still paying their mortgage but owes more than the home is worth. Pimco's Simon says the venture capital firm targeted private-label securities, which make up just 9% of the total market for first lien mortgages, because trustees of the securities typically take a passive role and would be less likely to take legal action.

"What they did that was smart in going private label because if they went after the GSEs or bank loans, lawyers would go after them instantaneously," says Simon. "The structural disadvantage is it's harder to sue, and the trustees don't care and they aren't paid enough to do anything."

Graham Williams, the chief executive of Mortgage Resolution Partners, says he recognizes that some of the loans that could potentially be seized would include securities owned by Fannie, Freddie and Federal Home Loan Banks. Williams says his firm singled out private-label securitizations "because the owners of those other loans have the ability to execute this program on their own, while securitized trusts are prohibited from executing this program on current loans."

A key issue in any legal fight would be how bond investors, including the government-sponsored enterprises and Federal Home Loan Banks, would be compensated for such seizures. Walter Dellinger, a partner at O'Melveny & Myers LLP and a former assistant attorney general, says San Bernardino County would face a slew of lawsuits and increased liability if the amount paid to bondholders is less than fair market value.

"There does appear to be a substantial gap between what the municipalities expect to pay for loans that they seize and the fair market value for performing loans in securitization trusts," Dellinger says. If San Bernardino manages to seize the loans using eminent domain, local governments would be required to compensate bondholders and the amount would be determined by the courts, he says.

But Williams says loans held by Fannie and Freddie have already been marked down to fair value, so the GSEs may not lose much money in the seizures. He cited estimates from Fannie's annual report of a 72.4% default rate on subprime loans as an indication of the prices that new investors would be willing to pay to purchase and then refinance the loans. His firm has hired the 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, which would then likely be refinanced.

"If we were to take one of those loans, we would price it very similar to where Fannie Mae has it on its books — that's a key point," Williams says. "If we buy one of those loans, the cash flow that Fannie Mae expects is probably very similar to what a third-party trying to value the individual loan would expect. They've already taken these losses and written them down to what they call fair value."

Bondholders say the only way the new investors could earn a return would be if bondholders receive less than fair value. "An underwater but paying loan doesn't trade at 60 cents on the dollar," says Simon. "They are cherry picking the best loans [with the intent of] buying them well below fair market value."

Dellinger agrees. "Built into the assumption is that the new investors at [Mortgage Resolution Partners] are going to make money only if something less than fair market value is paid to the original investors," he says.

Dellinger says it is hard to justify the seizure of properties through eminent domain if the homes are being taken care of by current owners and there is no blight to justify a benefit for the public good.

"When private property is taken not for governmental use but for the transfer to private investors, it raises questions of whether it is a legitimate public purpose," says Dellinger. "Even if this were a permissible taking of private property, a very serious question would arise as to what is just compensation."

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