Mortgage bondholders may be hit by modification push

By Al Yoon - Analysis

NEW YORK (Reuters) - Efforts by U.S. financial institutions to halt foreclosures are putting long-suffering investors that funded much of the American housing bubble at risk of incurring even bigger losses.

Housing finance giants Fannie Mae and Freddie Mac on Tuesday followed Citigroup Inc (C.N), JPMorgan Chase & Co (JPM.N) and Bank of America Corp (BAC.N) with a plan ease the terms on troubled home loans. Mortgage servicing companies will tear up existing contracts and give borrowers new loans on less onerous terms.

The wealth destruction must manifest itself somewhere, and under new plans it could increasingly be felt by investors already suffering massive market value write-downs of bonds backed by bad loans. Mortgages and related securities have caused more than $600 billion in financial institution write-downs since mid-2007.

Investors hoping to ward off losses have hid behind legal contracts, which under some interpretations limit modifications to just 5.0 percent of loans in a deal.

"I don't think there's tremendous amount of sympathy out there for the bondholders," said John Anderson, a senior vice president at Quantum Servicing Corp. in Shelton, Connecticut. "The momentum right now is to keep people in ther homes. It could jeopardize some of the bondholders."

The new efforts should increase the scope of loan modifications, which began to ramp up in 2007 as the U.S. Treasury banded industry leaders together to work collectively on foreclosure prevention, analysts said. Foreclosures in September 2008 rose 21 percent from a year ago, and are expected to rise through 2009 as they fuel a vicious cycle of home price declines.

Despite reports of more loans being modified, regulators and lawmakers are losing patience and taking measures such as foreclosure moratoriums. The new push by lenders may also be a step to avoid draconian action under a Democrat-controlled U.S. Congress, where some members have favored judicial decrees to keep people in their homes.

Barney Frank, the Democratic chairman of the House of Representatives Financial Services Committee, on Wednesday said the failure of servicers to prevent foreclosures in any "significant" way means legislation is now required.

The flood of announcements from banks comes as they find costs to foreclose now exceed the loss they may take in a modification. For subprime loans, the average foreclosure loss severity exceeds 50 percent, according to Ocwen Financial Corp., a large subprime servicer.

Modifications are well-intentioned. Homeowners get to stay in their houses at lower cost, and cash flows are revived. New underwritings can mean a lower interest rate, fee and principal forebearance or increasingly popular principal write-downs.

Investors still question modifications, however, doubting the process will leave them better off. With a dozen or more classes of investors in each deal, negotiations on who takes the loss can be frustrating.

"There's a level of dysfunction, where the organization that owns these loans cannot afford the write downs," said Ron D'Vari, chief executive of NewOak Capital in New York. "If they (accept write-downs) they blow themselves out of the water."

The expanded efforts by Fannie Mae and Freddie Mac announced on Tuesday will hopefully create a nationwide standard, said James Lockhart, director of the Federal Housing Finance Agency. Fannie Mae's clout is big, with its loans spread out over 1,400 servicers.

Controversy over modifications arises mostly with loans used as collateral for securities owned by thousands of bondholders, rather than "whole loans" owned by a single investor. About three-quarters of the $650 billion in delinquent home loans have been securitized, according to JPMorgan Chase & Co.

Countrywide, the big lender now owned by Bank of America, will surely be modifying mortgages currently locked up in bonds, since it owns just 12 percent of loans it plans to modify, JPMorgan's John Sim said in a recent report.