December 3, 2007 - Treasury Secretary Henry Paulson has been hard at work trying to prevent a rash of foreclosures that threaten to send the US economy into a recession. Specifically, he has been working to arrange voluntary agreements with mortgage lenders to freeze interest rates on many sub-prime loans, and he is apparently getting buy-in from many of those lenders. There is only one problem. A majority of the loans he is targeting for the rate freeze are only serviced by lenders but they are owned by investors. And there is a very good chance that these investors will sue if Paulson's plan negatively impacts their investment returns.

While Paulson has been the architect behind the discussions with lenders, the lenders themselves are trying to finalize what an interest rate freeze would actually look like. It is quite likely that such a freeze would only be offered to homeowners that actually reside in their homes. This would prevent real estate speculators from participating. It is also likely that anyone who owes more money on their home than it is worth would be eliminated.

Many lenders have been open to the idea of an interest rate freeze for a variety of reasons. Lenders know that mass foreclosures would hurt the banking industry as much as the rest of the economy. And lenders who don't sell off their loans on the secondary market have no interest in foreclosing on homeowners. They would much rather have performing mortgages than be property owners themselves.

But the wildcard in Paulson's plan are all of the investors that have purchased mortgage backed securities over the past several years. The value of these securities is heavily dependent on the interest rates charged on loans. If interest rates are frozen, then the value of the securities will drop.  The real question is whether investors believe that performing loans with capped interest rates will be more valuable than owning loans that may go into foreclosure. Nobody knows the answer to this.

A final plan to help bail out troubled homeowners may be announced as early as this week. Once that happens, it remains to be seen if investors will participate in the plan or sue to stop it dead in its tracks.

If a law suit does develop, investors may actually face another problem. Lenders who have been selling their loans on the secondary market have done a very poor job of tying individual loans to the securities that they secure. In a recent court case involving Deutsche Bank and homeowners that were being foreclosed upon, a Federal Judge ruled against the bank because the bank couldn't prove that it actually owned the mortgages on the homes. The bank admitted that it had sold the mortgages to investors and was only suing on their behalf. But it couldn't prove that it had the right to sue.

It is quite likely that investors in mortgage backed securities will face similar obstacles. If lenders don't know which of the mortgages they sold off are tied to individual securities, it is doubtful that investors will be able to prove that they own particular loans either.

If Paulson's plan does go into effect it is expected to target about 1 million homeowners who face increases in their sub-prime mortgage interest rates over the next year. The banks negotiating the plan still need to work out the details of how long an interest freeze would be in effect. 3 year, 5 year and 7 year time frame are all being considered.

by Jim Malmberg

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