The Federal Housing Finance Agency on Wednesday slammed plans by some local governments to use eminent domain to refinance underwater mortgages.

The agency, which oversees Fannie Mae and Freddie Mac, said seizing loans from private investors may increase taxpayer losses on the government-sponsored enterprises and ultimately spur a credit crunch in the mortgage market.

"FHFA has significant concerns about the use of eminent domain to revise existing financial contracts and the alteration of the value of enterprise or bank securities holding," the agency wrote in a notice.

The agency said it would take action, if necessary, to protect the operations of both GSEs and prevent any additional cost to the taxpayer. It stopped short of specifying what steps it could take.

Under eminent domain, localities purchase underwater mortgages out of a securitized package of loans at a steep discount, then write them down to fair value and create a new mortgage with a significantly reduced principal and monthly payment.

The FHFA warned that "resulting losses from such a program would represent a cost ultimately borne by taxpayers" and that it could "have a chilling effect on the extension of credit to borrowers seeking to become homeowners and on investors that support the housing market."

The notice by the agency follows a decision last week by the city council in Berkley, Calif. to endorse the potential use of eminent domain to refinance borrowers. Chicago and two California cities, Fontana and Ontario, are considering possible eminent domain plans.

Analysts anticipate that other municipalities will also announce plans to follow suit as well.

"Our view continues to be that at least one community will use eminent domain to refinance underwater borrowers," wrote Jaret Seiberg, a senior policy analyst at Guggenheim Partners, in a note to clients. "If that community is perceived to have helped voters, then we believe eminent domain use will spread to hard hit housing communities throughout the country despite FHFA's warnings."

But others said the plans were unlikely to proceed, especially in light of FHFA's opposition.

"We remain pessimistic about the ultimate potential of this plan succeeding in a scalable manner," Isaac Boltansky, a policy analyst at Compass Point Research & Trading, wrote in a note to clients. "The tone the FHFA has taken in this notice only reinforces our view that the eminent domain proposal will not come to fruition."

FHFA oversees entities that hold more than 15% of the $1.3 trillion of private-label mortgage-backed securities. Fannie and Freddie held $206.5 billion of private-label mortgage-backed securities at the end of May, according to the government sponsored enterprises' monthly summary reports. The 12 Federal Home Loan Banks held $17 billion of such securities, according to their first quarter combined financial report. The figures represent the unpaid principal balances of non-agency holdings.

FHFA has set a deadline of Sept. 7 for the public to comment on the issue.

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