Why modification is hard

The idea behind all these is simple. By modifying mortgages to reduce foreclosure rates, regulators and lenders are hoping to attack the financial crisis at its root. Fewer foreclosures could stabilize house prices and, by extension, the economy. A steady housing market would in turn take downward pressure off mortgage-backed securities, whose plunge set off the worst financial crisis since the Great Depression. Ultimately, all this would ease the strain on the banks that hold billions worth of these deteriorating securities on their books, allowing them to lend again and unfreeze the credit markets.

Trouble is, it's not that easy.

Any plan to modify mortgages is complicated by the packaging of individual loans into residential mortgage-backed securities, many of which were then used to back collateralized debt obligations. As market participants describe it, loan-modification plans pit investors in the securities against borrowers, the government and, in many cases, the mortgage servicers. "No one wants to say this aloud, but everybody wants to push investors over the side," says one structured finance specialist.

To understand what's at stake, it may be useful to understand what happens to a mortgage once it's issued. The simplest course would be a self-contained loop. The mortgage originator funds the loan, keeps it and services it. Modifying that mortgage is easy, which is why Citi and J.P. Morgan are focusing mainly on the loans they own as part of their modification programs.

In fact, J.P. Morgan's modification plan applies to only the mortgages it owns, 22% of the $1.5 trillion pool it services, according to a bank spokesman.

In the majority of cases, mortgages were sold, pooled, sliced into levels of risk and securitized as residential mortgage-backed securities, and the loan originators no longer own the mortgages. Rather, the mortgages have been placed in a trust, which, through a mortgage servicer, ensures that payments from borrowers flow in a steady stream to the investors in the RMBS pools.

Given this dynamic, chances are that any mortgage modification scheme would get entangled in multiple thickets of competing interests.

According to one mortgage investor, mortgage securitizations and the collateralized debt obligations that use RMBS to back them create internal pressures within investor groups. The most senior-rated investors -- those with the most security -- are often the most aggressive in opposing modifications and pushing for foreclosure, because the money gained from the sale of the underlying homes would flow to them first. Lower-rated investors, on the other hand, are more open to keeping borrowers in their homes in the hopes that a rebound in housing prices could, in the best case, save their investments and, at the very least, keep some cash flowing into investment pools.

"We could see class warfare in the trusts," one investor says.

Adding to the complexity is the role of mortgage servicers, whose own ability to modify the underlying loans is constrained by the so-called pooling servicing agreements, or PSAs.

Servicers are hired by trustees of the pools to manage the mortgage agreements. It is their responsibility to ensure a constant stream of payments to investors and, when the situations warrants it, to gain as much as possible from defaulted borrowers through foreclosures and property sales. In all cases, the servicers' priority is to maximize returns for the investors.

To adhere to tax codes beneficial to investors, the pools themselves are supposed to remain static and can be tampered with only under certain conditions. According to Hays Ellisen, a New York-based partner with Katten Muchin Rosenman LLP, "All pooling agreements give servicers some latitude [to modify the mortgage], but the ability to modify is extremely limited without adverse tax consequences unless the underlying mortgage is in default or it's reasonably foreseeable default will occur."

Default usually means a mortgage hasn't been paid for at least 90 days.

The degree of modification allowed is less standard. Some PSAs may allow, say, 5% of total loans to be modified. Others give servicers more discretion. A servicer may elect not to modify, even if default occurs, by continuing to make advance payments to the pool.