Housing bailout designed to avoid lawsuits but won't

By Diane Bartz - Analysis

WASHINGTON (Reuters) - The Bush administration's strategy of having major lenders help design its plan to handle the subprime mortgage crisis means that it will avoid most litigation -- but not all, according to lawyers who specialize in constitutional and contract law.

"Can there be legal challenges based on it? I think that there can," said Don Chase of the New York firm Morrison Cohen LLP. "To the extent that you're compelling a segment of people to essentially swallow the loss ... there's a constitutional argument to be made there."

"Any time that you're talking about billions of dollars being lost in the market, there's the smell of lawsuits," he said.

The plan, which Treasury Secretary Henry Paulson announced on December 4, would freeze rates on subprime adjustable rate mortgages for borrowers who cannot afford a loan's built-in interest rate spike.

Many of the people whose interest rates will be frozen would have been contractually obligated to pay higher rates but they would also avoid foreclosure -- which means the homeowner is out in the cold but also means the lender is responsible for an empty house instead of receiving a steady flow of cash.

"You start from the point that the president and officials are negotiating with lenders and others about what they would expect," said Chase. "They (lenders) may decide that this is better than nothing (foreclosure) or that this is a reasonable compromise."

"I'm sure there are people with calculators trying to figure out how this will affect them," he said.

LEGAL COVER

Barry Sher, of the law firm Paul Hastings, said owners of mortgage-backed securities may well file suit. "You're likely to have litigation over the plan because you are altering contractually established rights," he said.

The plan has been endorsed by the American Securitization Forum, which represents investors and mortgage securitizers. Their support is expected to give some legal cover in the case of suits.

Joshua Schwartz, of the George Washington University law school, argued that the sheer expense of foreclosing and the stringent criteria to take advantage of the rate freeze meant that lenders would be major beneficiaries of the plan.

"My first inclination would be to say: What bailout?," he said, adding that the plan was negotiated rather than imposed by the government, that it was voluntary and that most people in trouble over their mortgages were not covered.

"The government encouraging banks to renegotiate loans isn't unconstitutional even if it reduces the value of mortgage-backed securities," he said. "It's not real clear to me there's a legal violation."

"Smart lenders don't like foreclosing," he said. "They need to be able to do it but, the idea is that there's some sweet spot where it's better for the industry to renegotiate rather than foreclose, so to some extent this is the industry doing what is in their self interest."

(Editing by Brian Moss)