Subprime mess - no easy fix

NEW YORK (CNNMoney.com) -- Swapping risky mortgages for those with steady payments sounds like a reasonable plan to keep millions out of foreclosure. But the way mortgage products have been packaged and sold into financial markets presents a big hurdle.

At a Congressional hearing Tuesday, several speakers - including lawmakers, activists and real estate professionals - called for loan modifications that would move troubled borrowers out of adjustable-rate mortgages, forgive late penalties and add late-payments to the end of the loan.

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But this kind of restructuring may be complicated because most of the loans have been "securitized," bundled together and sold into the capital markets.

When that happens, mortgage service companies are engaged to run the operations, and there are only limited steps they can take when borrowers get into trouble. No longer is there a Jimmy Stewart at the loan office who can step in.

According to Sheila Bair, Chairman of the Federal Deposit Insurance Corporation, who spoke at the hearing, nearly 75 percent of all subprime loans extended in 2004 and 2005 were sold in the secondary market.

"I'm concerned with the distance [securitization puts] between lender and borrower," said Congressman Ed Perlmutter, Democrat from Colorado.

In the first place, servicers don't have quick access to the actual groups that own these loans, which may be pension plans, individual investors, insurance companies and mutual funds. Perhaps 50 percent of the mortgages securitized during the past few years have been bought by foreign investors.

A bigger problem may be that the servicers' contracts with investors often prohibit them from taking remedial actions with non-performing loans.

"Subprimes sold into securitization are governed by terms of agreements signed when they were sold. Servicers have to abide by those agreements," says Doreen Woo Ho, president of Wells Fargo Consumer Credit Group.

Those terms may, for example, not allow the loan to be modified until it is at least 90 days delinquent, according to Marietta Rodriguez, a director of Homeowners Initiatives for NeighborWorks, a non-profit, community development organization. Once borrowers fall that far behind in payments, it can become very difficult for them to recover.

In addition, the agreements between servicers and investors may not allow borrowers to work out their problems unless they can bring their payments current within a six-month period, according to Rodriguez. "That puts the borrower in a serious financial bind," she says.

Tax regulations make it difficult to rewrite the terms of securitized loans. The loans are bundled as Real Estate Mortgage Investment Conduits, or REMICs, which provide tax benefits for the investors. However, by Internal Revenue Service rules, that tax status precludes REMICs from modifying the loans unless certain conditions are met, according to the FDIC's Bair.

One of these exceptions is when default is reasonably foreseeable. But that makes the exception dependent on the facts and conditions of each separate loan.

To cover its responsibilities, the servicer would probably want to clear the details of each case through counsel, which can take lots of billable hours, and wait until the loan is in arrears by 60 days or more. The delay often means the borrower gets deeper in debt.

The inflexibility of these terms benefit neither the borrowers nor the investors. "Investor interests are aligned with borrowers," said George Miller, executive director of the American Securitization Forum, who represented investors at the hearing. The average foreclosure costs as much as $60,000 to wipe off the books.

Another impediment that can work against bailout efforts is stratospheric home prices. Some of the bailout plans call for loans to be bought up by Fannie Mae (Charts) and Freddie Mac (Charts, Fortune 500), the government-sponsored, mortgage finance companies.

But many homes bought with subprime loans are in places like California and other high-cost areas where even many modest homes far exceed the conforming loan limits of these agencies, which is about $417,000.

In other words, Freddie Mac would not be permitted to buy a restructured mortgage for the average home in San Francisco, where the median house price is more than $718,000, according to the National Association of Realtors, or in San Jose ($740,000), Los Angeles ($568,00) or many other metropolitan areas.