Mortgage company 'safe-harbor' idea lives, for now

NEW YORK May 1 (Reuters) - A controversial move to provide legal protections to mortgage companies as they modify risky loans has survived the defeat of legislation that included it, according to an investor and a Washington source.

The U.S. Senate on Thursday rejected an amendment that would give bankruptcy judges the power to revise residential mortgage contracts. Senators sided with banks, which say it would increase risk premiums passed on to consumers.

But lawmakers are still considering the "safe-harbor" for mortgage servicing firms, vilified by community groups for slow responses to foreclosures. The firms say fear of lawsuits has kept them from more actively easing loans.

Many of the riskiest loans are collateral in mortgage asset-backed securities governed by legal contracts, which adds a layer of complexity.

Investors mobilized against "safe-harbor" say servicing companies will ramp up modifications for their own benefit and break their fiduciary duty to maximize returns on the bonds, which have wreaked havoc on financial companies and pension and mutual funds.

Blocking such modifications, known as "cram-downs," "is a very good development," said Bill Frey, president of Greenwich Financial Services in Greenwich, Connecticut. "However, the main risk to the U.S. economy and pensions is the 'safe-harbor.' It would shift massive losses from the banks to pension funds and middle-class investors."

Industry groups are working with Congress to craft a compromise so that contracts are respected and some legal protection is provided for the servicers, Frey said.

Greenwich Financial is leading a lawsuit against Bank of America-owned Countrywide Financial, asserting that the mortgage company will shift $8.4 billion in modification costs to mortgage bond trusts, harming investors. The lawsuit demands Countrywide buy back every mortgage for which it agreed to cut payments under a predatory lending deal struck with state attorneys general.

A report by Amherst Securities this week found at least one case in which a servicer engaged in "sham-mods," which renewed loans only by pushing missed payments into the balance.

Such modifications benefit servicers, who recapture the principal and interest they had to forward to investors while the loan was in default, according to Amherst. Payments to servicers are taken from the bond trust, hurting investors.

What's more, homeowners are unlikely to benefit because re-defaults occur on 70 percent of the modified balance five months after the modification is completed, the Amherst report found, using data from Loan Performance, a mortgage data provider.

Under the provision currently being negotiated, servicers must demonstrate that a modification will benefit bondholders and result in the best possible value of the underlying loans.

But Amherst noted that servicers are also free to select data that will provide the results they desire. (Editing by Dan Grebler)