Loan modifications

a private investor in mortgage-backed securities, filed a lawsuit in New York State Supreme Court on December 1st alleging that the proposed modification of some 400,000 home loans originally underwritten by the defunct lender Countrywide Financial is illegal.

The lawsuit, which seeks class-action status, was filed against Bank of America, which bought Countrywide in late 2007. Frey argues that most of the Countrywide loans are not Countrywide's or Bank of America's to modify, but rather are owned by trusts that bought them through securitization.

In an article published by BusinessWeek.com, Frey claims that BofA’s modifications will short bondholders $8.4 billion by reducing borrower payments. While those loan adjustments may help to keep struggling borrowers in their homes today, Frey says those alterations run the risk of permanently damaging the secondary market for housing finance.

At the heart of the issue is how loans are packaged and securitized. Typically once a loan is originated it is packaged and sold off to investors. These securities are called Mortgage Backed Securities or MBSs. These MBSs are purchased by trusts put together by Wall Street bankers. When borrowers pay interest and principal on their mortgage loans, those payments go to the trusts, not to the lender that initially made the mortgage loans. To raise the money to buy or fund the loans, the trusts sell interests in a pool to investors or bondholders. Therefore, when banks modify the terms or principle amount of the loans held by the trusts it is the trust not the bank that takes the loss.

"I am an advocate for investors' contractual rights," says Frey, 50, in the interview. He has publicly argued since March that loan modifications are against contract law, and has threatened to sue banks -- despite, he says, receiving pressure to back down from Washington.

"Investors' voices have been muted in this debate because they speak of an inconvenient truth: Current solutions sacrifice the long-term viability of this nation's housing finance system for short-term political gain. No matter how noble the intent, it is not in the interest of the United States now, or in the future, to tell its citizens and the world at large that U.S. contract rights may be bent with the political winds," added Frey.

While so far Frey is the only member of the proposed class against BofA, Frey says he's on a crusade on behalf of all large investors who bought Triple A-rated mortgage bonds, and not just those who bought bonds backed by Countrywide mortgages. The suit alleges that modifications favor bondholders who bought the riskiest pieces. Normally those investors should suffer losses first, but that's not what's happening in the current wave of workouts, according to the suit.

In another published report, BofA spokeswoman Shirley Norton says: "We have not yet received a filing and, therefore, we cannot comment on specific claims. We are, however, disappointed in this attempt to halt a program intended to keep as many as 400,000 at-risk families in their homes and, together with similar programs across the industry, stabilize the nation's housing market. We are confident that together with the attorneys general we have built a program that benefits both consumers and investors, whose interests we carefully considered in developing our program."

Frey suggests that a solution would be for the government to buy all the troubled loans from mortgage-backed securities pools at a price tag of roughly another $500 billion. Under Frey’s plan bondholders would be made whole and the government -- that is taxpayers -- would then have their investment reduced when loans are modified.

If successful, the suit may put a halt to modification of loans without getting permission from the trusts who ultimately own the loans.