Roadblock to a subprime solution

The biggest obstacle to a mortgage bailout plan could be the investors who wound up with the bad debt.

A sweeping solution to the subprime lending crisis could get snagged by a big sticking point at the end of the mortgage chain.

On Monday, Treasury Secretary Henry Paulson said in a speech that its Hope Now coalition of government, industry and community groups is developing a streamlined way to move able homeowners into sustainable mortgages.

A large part of that plan, it's been widely reported, is to broadly rework adjustable rate mortgages (ARMs) for all borrowers who qualify and freeze their interest rates before they jump to unaffordable levels.

But investors in mortgage-backed securities, who buy the loans wholesale from lenders, aren't exactly jumping on board.

"You have contracts in place guaranteeing investors a fixed rate of returns," said Jim Carr, Chief Operating Officer of the non-profit advocacy group, National Community Reinvestment Coalition. "They have no immediate incentive to give up those returns."

Modification options for mortgage servicers are limited by contracts and tax laws. Servicers decide who would or would not qualify for a loan rework, but they can't make widespread modifications without an okay from investors.

Contracts between lenders and investors typically state that servicers can modify up to five percent of loans within a group without clearing it in advance. But modifying a higher percentage requires approval. The reworks called for by Secretary Paulson would probably exceed that five percent threshold in many cases.

But relaxed guidelines in October from private watchdog the Financial Accounting Standards Board gave servicers greater leeway in reworking loans if the modifications were in the best interest of investors.

The move was supposed to give the green light to a large-scale reworking of potentially delinquent loans. But investor reluctance stills seems to be a hurdle in applying the fix to an entire group of borrowers.

The American Securitization Forum (ASF), which represents investors and is part of Paulson's coalition, supports easier ways to modify mortgages for troubled borrowers, but according to spokeswoman Katrina Cavelli, it does not back an across-the-board solution to the problem.

In congressional testimony Friday, ASF Deputy Executive Director Tom Deutsch said that certain modifications are preferable to foreclosures, but they "should be considered and made on a loan-by-loan basis."

"There's a lot of technical work that has to be done before this program can be put into place," said Carr. There's also a rights issue, he said. "It could be argued that all borrowers within a group be treated the same."

Then there's the threat of investor lawsuits. Contracts between mortgage servicers and investors typically have two competing clauses, according Joe Mason, professor of finance at Drexel University. One requires servicers to act in the best interest of investors, and the other sets specific limitations on what servicers can do, including what modifications to loans can be made.

"Modifications are proceeding," said Mason, "and servicers are using the 'best interest' clause. It's not clear if that opens them up to investor lawsuits. It will be up to the courts to decide which clause wins."

Ultimately a mortgage rate freeze would result in higher home prices, according to Peter Schiff, president of retail investment brokerage Euro Pacific Capital.

"The [investor] will say, 'Wait a minute. The government can come back in a few years and alter contracts based on economic emergencies,'" he said.

Investors will want a higher return from their securities, and charge more for that added risk. "Because of government intervention, people will pay too much for their houses."