Subprime aid plan may have legal fallout: experts

By Martha Graybow and Paritosh Bansal

NEW YORK (Reuters) - Legal action could be on the way from mortgage investors who oppose a U.S. government-backed plan to freeze interest rates for troubled borrowers, though experts say it is unclear whether they would have a strong case.

Investors who hold mortgage-backed securities may be spurred to sue if they insist on enforcing the terms of struggling homeowners' mortgages -- and get the loan income they were initially promised -- rather than allowing loan modifications as proposed under the relief plan supported by the U.S. Treasury Secretary.

"It certainly seems as though it is going to cause pain to (those) who may not be realizing the benefit of the loans," said attorney Adrian Zuckerman, head of the real estate practice at law firm Epstein Becker & Green.

"And historically whenever someone is subjected to that, it's resulted in lawsuits," he said.

The aid plan is expected to be finalized between major mortgage lenders, servicers who collect mortgage payments and the Treasury Department this week, as political pressure increases to prevent more foreclosures and a wider U.S. housing slump.

Under the tentative plan, adjustable interest rates would be frozen for some homeowners facing foreclosure before their loans become fixed at a higher level. Under such a scenario, the investors who bought mortgage securities tied to these subprime loans likely would get lower returns than they had bet on.

These investors could make a legal case that they took on the risks of the loans and now will not be getting the return they were promised, said Ron Geffner, a partner at law firm Sadis & Goldberg who represents hundreds of hedge funds.

Many hedge funds, along with other institutional investors such as mutual funds, money market funds and retirement plans, are invested heavily in mortgage securities. Some hedge funds in particular made strategic bets on the decline of the subprime mortgage market, and they could argue that the government-backed plan is unfair meddling that will cheat them out of money.