The Federal Housing Administration may not be on board with proposals under consideration by some cities and counties to seize underwater mortgages through eminent domain and refinance them into government-backed loans.

"It's a local issue, but the FHA is concerned about the approach," an Obama administration official said. The source asked not to be named because of the still-evolving proposal and sensitivity to the authority of local governments.

The investment firm Mortgage Resolution Partners pitched the idea to several governmental entities in areas hit hard by the housing crash. Using funds raised by MRP, local governments would seize the underwater mortgage and allow the investors to write down the principal and refinance the loan into a new FHA-backed mortgage.

Mortgage bond investors and analysts claim the approach is unlawful and doubt fair market value would be used when seizing the loans. Foreclosure expenses and servicer advances would likely be taken off the appraised value of the property, even though borrowers targeted by the proposed plan are still performing on their loan.

One MRP investor, who also asked not to be named, claimed local governments would offer more than the appraised value to avoid more controversy.

The FHA faces a unique position. The Obama administration will renew efforts in September to pass federal legislation helping more underwater borrowers refinance through a variety of proposals. But the FHA must also protect a fragile emergency mortgage insurance fund from additional risks posed by insuring new loans for severely underwater borrowers.

Borrowers in some of the targeted areas got there through cash-out refinances and by putting very little or no money down in the first place, according to analysts.

Without a $1 billion origination settlement with Bank of America (BAC) earlier this year, the FHA fund would have required an unprecedented bailout from the Treasury Department. Severely delinquent mortgages backed by the FHA began increasing again this summer.

The Federal Housing Finance Agency deemed principal reduction too much of a risk for Fannie Mae and Freddie Mac and closed the door on this approach in July, even after the Treasury offered more dollars to offset the cost.

San Bernardino County, Calif., residents, those most likely to benefit from such a program, lined up at a local meeting last week to condemn the proposal. Many in the area grew suspicious of their officials for allowing private investors to profit from such power as eminent domain.

The San Bernardino Special Authority did pass a formal request for proposals to combat the negative equity problem in its area. Roughly 43% of homeowners in the county owe more on their mortgage than their home is worth.

Chicago Mayor Rahm Emanuel also pushed back against the proposal after local city aldermen met to consider the plan.

Mortgage industry trade groups are planning to meet in D.C. to go over the legal and market consequences of the plan. The FHFA warned governmental entitites considering eminent domain that adopting such a idea could mean Fannie and Freddie would stop or reduce financing mortgages in areas that pose such unique and unpredictable risk.

Until now, the FHA remained silent on the idea, but the administration source signaled the developments are being watched carefully.

Mortgage bond analysts, meanwhile, believe the idea is losing momentum as dissent mounts.

"Eminent domain is looking increasingly unlikely," said JPMorgan Chase (JPM) securities researchers.

jprior@housingwire.com

@JonAPrior