If several California cities move ahead with a plan to seize underwater mortgages, they could end up paying more for the loans they expected, according to a legal expert retained by the Securities Industry and Financial Markets Association (SIFMA).

Walter Dellinger of O’Melveny & Myers LLP told reporters on Tuesday the use of eminent domain to seize mortgages out of private-label securities would diminish the value of the overall pool of securitized loans.

“If that is the case, then the authority taking the property will be responsible for compensation not just for the value of the particular loans themselves, but also the damage done to the rest” of the securitized pool.

San Bernardino, Ontario and Fontana are considering a plan to purchase the underwater loans of their residents at fair market value so they can be refinanced by Mortgage Resolution Partners, San Francisco. This plan would effectively provide the homeowners with a principal reduction. House prices in those cities have declined by 40% to 50% since 2006.

Dellinger also told reporters that the refinancings will only be extended to performing loans and the cities expect to purchase the loans based on the market value of the underlying property. “It seems to work only if the existing note holders receive less than the fair market value,” he said.

The plan also calls for a “quick-take” process, the attorney said. The loans would be seized and refinanced before the court determines the fair market value.

If Mortgage Resolution Partners has underestimated the fair market value of the loans or the damage to the other MBS investors, “the cities will be liable for that underfunded amount,” Dellinger said.

The O’Melveny & Myers attorney noted that this “unprecedented” use of eminent domain raises multiple questions under the U.S. Constitution and California state law.

Under the constitution, the taking of private property must for a public purpose. Proponents of the refinancing plan claim it will reduce foreclosures and blight.

But Dellinger said it appears to transfer wealth from one group of investors to another group of investors once the newly refinanced mortgages are securitized and sold. “It raises questions of whether that is a legitimate public purpose.”

SIFMA managing director Tim Cameron said the proposed plan would “do substantially more harm than good.”

It targets loans in private-label securities that are performing, Cameron said, and it will involve a very small percentage of properties. “This will do little or nothing to eliminate or prevent public blight in any of the neighborhoods.”

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