Investor Sues to Block Mortgage Modifications

A lawsuit against Bank of America claims states and banks will short bondholders $8.4 billion and damage the market by cutting home payments

By Mara Der Hovanesian

The battle over the mass modifications of troubled mortgages has begun in earnest. On Dec. 1, William Frey, a private investor in mortgage-backed securities, filed a lawsuit in New York State Supreme Court 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 (BAC), which bought Countrywide in late 2007. It 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—the process of financing home loans through the public markets by parceling them out to investors.

Frey says that BofA's modifications (BusinessWeek.com, 10/23/07) 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.

"I am an advocate for investors' contractual rights," says Frey, 50, in an interview. He has publicly argued since March that loan modifications (BusinessWeek, 11/26/08) 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."

Bank of America Response

In response, Bank of America 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 says a more reasonable, albeit unpopular, solution would be for the government—that is, taxpayers—to ante up another $500 billion to buy all of the troubled loans from mortgage-backed securities pools in order to keep the public market for financing mortgages viable. (There have been roughly $7 trillion in mortgages financed by global public markets since 2002, according to ThomsonReuters. Of course, not all of those loans are troubled.)

Securitization massively expanded home ownership in recent years by allowing investors to price the risk of less credit-worthy borrowers. But investors in some of the prime securities are angry about having to foot the bill for reworking the most risky mortgages. The chief risk manager for a mortgage investment company, who spoke on condition of anonymity, said that BofA isn't paying for the modifications out of its own pocket, but "out of the bondholders' money. That's pretty egregious."

To raise money to lend, banks and mortgage players such as Countrywide sold some of their loans via Wall Street. When loans are securitized, Wall Street bankers create trusts that buy them. 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. These notes are securities—hence the term "securitization."

Each note entitles its owner to payment of principal, plus interest, at an agreed-upon rate until the loan is paid off. According to the suit, modifying a mortgage loan almost always means reducing or delaying payments due on a loan. Reducing or delaying those payments in turn entails a reduced or delayed flow of funds into the trusts. A reduced or delayed flow of funds into those trusts reduces the value of the certificates that those trusts sold to investors, the suit says.