Experts See Legal Fallout From Subprime Plan

Legal action could be on the way from mortgage investors who oppose a U.S. government-backed plan to freeze interest rates for troubled borrowers, though experts say it is unclear whether they would have a strong case.

Foreclosured Home
David J. Phillip
Foreclosured Home

Investors who hold mortgage-backed securities may be spurred to sue if they insist on enforcing the terms of struggling homeowners' mortgages -- and get the loan income they were initially promised -- rather than allowing loan modifications as proposed under the relief plan supported by the U.S. Treasury Secretary.

"It certainly seems as though it is going to cause pain to (those) who may not be realizing the benefit of the loans," said attorney Adrian Zuckerman, head of the real estate practice at law firm Epstein Becker & Green.

"And historically whenever someone is subjected to that, it's resulted in lawsuits," he said.

The aid plan is expected to be finalized between major mortgage lenders, servicers who collect mortgage payments and the Treasury Department this week, as political pressure increases to prevent more foreclosures and a wider U.S. housing slump.

Under the tentative plan, adjustable interest rates would be frozen for some homeowners facing foreclosure before their loans become fixed at a higher level. Under such a scenario, the investors who bought mortgage securities tied to these subprime loans likely would get lower returns than they had bet on.

These investors could make a legal case that they took on the risks of the loans and now will not be getting the return they were promised, said Ron Geffner, a partner at law firm Sadis & Goldberg who represents hundreds of hedge funds.

Many hedge funds, along with other institutional investors such as mutual funds, money market funds and retirement plans, are invested heavily in mortgage securities. Some hedge funds in particular made strategic bets on the decline of the subprime mortgage market, and they could argue that the government-backed plan is unfair meddling that will cheat them out of money.

Geffner said he has not been approached by any of his hedge fund clients about filing a lawsuit connected with the expected borrower relief plan, but he said that he would not be surprised if some litigation emerges.

Still, he said, it is unclear who the potential defendants would be and what specific legal claims would be brought. He said it's possible that investors could sue the government as well as lenders. Possible claims could include breach of contract, or tortious interference -- the causing of harm by interfering with a contractual relationship.

If the plan goes into effect, some investors would be tempted to support it so that they could preserve the stream of income that would come from avoiding foreclosures, experts say.

But some investors may not necessarily be concerned about foreclosure because they would be among the first in line to be paid out when a borrower defaults and foreclosure begins.

Investors may have a case if the contract they signed does not provide for major loan modifications, said David Galainena, a partner at law firm Winston & Strawn.

"If the document does not provide for a modification like this, which I doubt if it does, then I would think they would have potentially legal recourse against the servicer of the deal," he said.

But others say they do not expect much litigation to emerge because they only think a broad-based plan can be reached if all major players, including the investors, are on board.

"They are a constituency which has a lot to lose, but is able to get its point of view represented in the process, so I would think that as the deal is hammered out, their concerns and considerations will be part of that process and will be resolved," said Seth Leventhal, a partner at law firm Dorsey & Whitney.