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Dispute Among Wall Street Titans Could Affect Millions Of Mortgages At Risk Of Foreclosure

Updated:
WASHINGTON (AP) _ Millions of Americans with weak credit who took out mortgages the past few years are caught in a tug of war between hedge funds and lenders on Wall Street.

Who wins the dispute could have more impact on how many homeowners get financial help to avert default and foreclosure than anything Congress or regulators are contemplating in the near term.

Washington seems to be taking a wait-and-see approach even as the housing market's woes worsen. Foreclosures in 2007 are twice what they were two years ago at this time.

And monthly payments on more than 8.4 million adjustable-rate mortgages issued since 2004 will be affected by rising interest rates on reset dates the next few years. Research firm First American CoreLogic predicts $326 billion, or 13%, of outstanding loans will default.

Publicly, officials at banks and hedge funds say they want to do all they can to help distressed homeowners.

Privately, however, a debate simmers over whether banks that sold bundled mortgages to institutional investors can legally pluck loans out of those bundles for workouts to help keep the default rates down.

However, which homeowners get chosen for financial help by lenders might be influenced by billions of dollars worth of contracts _ called credit-default swaps _ negotiated the past few years between lenders and investors, hedge funds allege.

Lenders say they have the legal right and want to pull out some distressed loans and rework or reissue them, taking a financial hit if need be, to keep mortgage-holders in their homes.

Hedge funds argue that the real motive might be to avoid paying what lenders owe on complicated financial contracts negotiated on the mortgages.

Instead of having to pay on a contract at as much as 100 times the value of the underlying mortgage, ``it becomes cheaper for some folks to buy worthless loans,'' says Harvey Pitt, a former chair of the Securities and Exchange Commission who represents a hedge fund.

Unregulated hedge funds effectively assumed some of the risk lenders faced when they issued mortgages to borrowers with risky credit histories. Lenders, in turn, agreed to pay hedge fund investors if the value of defaults soared on bundled mortgages sold to institutional investors.

If the value of defaults stays below a certain level, hedge funds lose and owe lenders a negotiated amount. Led by Bear Stearns Cos., lenders say banks can legally alter bundled mortgage pools, regardless of whether a default-risk swap is attached.

For homeowners, ``there are real consequences to the failure of these mortgage loans beyond the fact that a lot of rich guys didn't get as rich as they hoped to get,'' said Ira Rheingold, executive director of the Washington-based National Association of Consumer Advocates. ``We're talking about homes. We're talking about communities. It's not just a mere economic calculus.''

Tom Marano, global head of mortgages for Bear Stearns, insists the firm buys out or modifies mortgages when there is a good chance that homeowners will be able to become current on their payments. In making adjustments, lenders are well within their legal rights, which have been fully disclosed and in practice for decades, he added.

Pitt says it would be market manipulation if lenders are trying to avoid paying on swaps.

``So far people are talking about wanting to do this, but I'm not aware yet that anybody's actually tried to do it...the important thing for folks to realize is that it's unlawful,'' Pitt says. ``There can be litigation if anybody tries,'' he added.

More than 25 hedge funds, led by New York-based Paulson & Co., want the trade group that regulates their industry to weigh in on the dispute.

Paulson, which stands to profit immensely from bets it made on the subprime mortgage market's downturn, hired Pitt, of Washington consulting firm Kalorama Partners LLC, to press its case.

The International Swap Dealers Association trade group says it is studying the issue and will issue a comment but has not promised a date for doing so.

In an e-mail Tuesday, Robert Pickel, chief executive of ISDA, said the group's rules ``make expressly clear that parties must not only comply with the law but must also observe sound practices and principles in the conduct of such business.''

However, he added that, ``individual firms are free to adjust (ISDA's recommended contract language) when negotiating their contracts bilaterally.''

Federal Reserve Chairman Ben Bernanke, in a May 15 speech, seemed to indirectly address the issue. ``Securities laws against insider trading and market manipulation apply broadly to all financial institutions, including hedge funds, and to trading in a wide range of financial instruments,'' he said.

Christopher Whalen, a New York-based managing director for Institutional Risk Analytics, which analyzes corporate risk, says he doubts whether hedge funds that speculate on mortgage defaults can legally interfere with a lender on a specific mortgage.

``The borrower has rights, the lender has rights,'' Whalen said. ``If they want to re-negotiate the terms of that relationship, that's their business.''

Experts say it could be tough to prove that a lender deliberately suppressed the delinquency rate of a pool of thousands of mortgages, all with different circumstances.

``It's a difficult case to make,'' said Kevin Byers, an Atlanta-based forensic accountant who specializes in residential real estate and mortgage securities.

At least some hedge funds are still betting they'll profit from the downturn. They're snapping up subprime mortgage companies or pools of subprime loans at bargain prices, market observers say. In recent months, some of the biggest buyers include Ellington Capital Management, Fortress Investment Group. Citadel Investment Group LLC, Lone Star Fund V LP.

Meanwhile, homeowners may be asking to what extent they might be affected by the legal questions surrounding the default-risk swaps.

``It's almost like gambling ... It doesn't make sense at all,'' says April West, 22, who lives north of Milwaukee. She refinanced her monthly mortgage payment from about $2,000 a month to about $1,100 with help from the National Community Reinvestment Coalition, a consumer group.

``Why would they sit around making bets like we're little toys?'' West wonders.
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