Mortgage investor and homeowner advocacy groups made their cases to the Chicago City Council Tuesday over a controversial plan to seize underwater mortgages through eminent domain and refinance them into government-backed loans.

Chicago is one of several areas, starting with San Bernardino County, Calif., considering a proposal to use capital raised from a group led by Mortgage Resolution Partners. The city would buy still current home loans for below market value, write down principal and refinance them into a Federal Housing Administration mortgage. The MRP group would earn back interest on the new mortgages for their investment and local governments could return some equity to homeowners.

But Timothy Cameron, managing director for the Securities Industry and Financial Markets Association, warned the Chicago City Council at a special hearing Tuesday morning that if they went ahead with the plan, credit could soon dry up as bond investors flee.

"We need mortgage investors and lenders to come back to these fragile markets — but this plan will force both groups to avoid them," Cameron said. "If the city of Chicago were to adopt MRP's plan or another like it, it would position itself as a facilitator of a group of opportunistic investors' unjust, and likely unconstitutional, efforts to extract profits from a different group of investors. This would put the city at risk of being drawn in to expensive legal disputes."

Opponents point out the investors bought into these high-interest bonds with the understanding that many of the borrowers would refinance and prepay out of the securities by now anyway. The busted housing bubble and an unprecedented evaporation of equity keeps the borrowers from doing so.

Tom Feltner, vice president of public policy at Woodstock Institute, told the council 26% of Cook County borrowers owed more on their mortgage than their home was worth. And roughly 40% of homeowners in predominantly black and Latino communities were underwater, he said.

"Without question, the public good and economic security of Chicago's communities is improved when foreclosure can be avoided through a principal reduction," Feltner said.

The Federal Housing Finance Agency weighed in on the issue in a statement last week, expressing "significant concerns" with the proposals so far. As regulator for the two largest mortgage financiers in the country — Fannie Mae and Freddie Mac — the agency warned it may take action if the plans are adopted.

"The nuclear option would be to forbid the GSEs from guaranteeing future loans in counties that adopt eminent domain," securities analysts at JPMorgan Chase (JPM) said in a recent note. "The denial of credit would make the cost of adoption so high as to effectively kill it."

Analysts added the agency could direct the GSEs to price in the eminent domain risks of guaranteeing loans in these areas as well.

Tom Deutsch, executive director for the American Securitization Forum, also warned the Chicago leaders Tuesday about the effects of investors and lenders pricing in that risk.

"The plan will make new mortgages harder and more expensive to get because lenders will need to take into account the risk of losing their loans through eminent domain," Deutsch said.