A former Fannie Mae executive is warning that plans being considered by several California localities to use eminent-domain laws for seizing and refinancing underwater mortgages will create more problems than solutions.

"This use of eminent domain will face serious legal challenges, and any attempt at implementation is fraught with problems," says Edward Pinto, former executive vice president, chief credit officer and senior vice president of marketing and product management at Fannie Mae and a resident fellow at the American Enterprise Institute (AEI), a Washington, D.C.-based think tank. "It certainly is not the free lunch being pitched to localities."

Pinto warns that legal problems may arise over whether eminent domain is being invoked for public use, adding that this could be litigated in the courts for years. He also stresses that the seizure of property has repercussions if the mortgages have been securitized.

"It strikes at the heart of the contractual relationship underpinning the securitization of mortgages and the relationship between lender and borrower," he says. "As with many of the actions that have been taken that are anti-investor, this will materially impact investors’ willingness to buy private mortgage-backed securities and to risk the capital needed to support these securities.

"Since this plan would be implemented locally," Pinto adds, "investors could decide not to invest in securities from these areas, raising rates for many borrowers in the effected localities, thereby making matters worse. This approach would be on top of other anti-investor actions. For example, private investors were not a party to the states' attorneys general national mortgage settlement, which provided for principle reduction paid from investor funds."

Pinto also states that eminent domain seizure is predicated on the pessimistic belief that none of the loans being targeted for government takeover will ever be paid off.

"This is akin to buying a right-of-way for a limited-access highway and condemning the more valuable portion of a property that fronts a road, but valuing that frontage based on lower non-frontage rates," he says. "Fundamental fairness would prohibit such cherry picking."