By ROBBIE WHELAN and RUTH SIMON
For mortgage investors, the recent suspension of foreclosures could potentially cause further losses in the already-battered $2.8 trillion market for residential mortgage-backed securities.
In the past two weeks, three major loan-servicing companies put thousands of foreclosure sales and evictions on hold in the 23 U.S. states where foreclosures are handled by the courts. On Tuesday, House Speaker Nancy Pelosi called for a federal investigation into the issue.
"We urge you and your respective agencies to investigate possible violations of law or regulations by financial institutions in their handling of delinquent mortgages, mortgage modifications, and foreclosures," Ms. Pelosi and 30 other California House Democrats said in a letter sent to Federal Reserve Chairman Ben Bernanke, Attorney General Eric Holder and John Walsh, the acting comptroller general of the Treasury.
The stoppage is but the latest frustration for bond investors, who have wrestled for more than three years with a market in disarray.
"It's symptomatic of sloppy servicing and a lack of adherence to contract and property law, which we've seen examples of over and over again in the last two years," said Scott Simon, a managing director at Pacific Investment Management Co., or Pimco, a unit of Allianz SE.
While it is unclear whether the delays will have a deep impact on the market for bonds, the changes are already creating some unexpected outcomes, say investors.
When houses that have been packaged into a mortgage bond are liquidated at a foreclosure sale—the very end of the foreclosure process—the holders of the junior, or riskiest debt, would be the first investors to take losses. But if a foreclosure is delayed, the servicer must typically keep advancing payments that will go to all bondholders, including the junior debt holders, even though the home loan itself is producing no revenue stream.
The latest events thus set up an odd circumstance where junior bondholders—typically at the bottom of the credit structure—could actually end up better off than they expected. Senior bondholders, typically at the top, could end up worse off.
Not surprisingly, senior debt holders want banks to foreclose faster to reduce expenses. Junior bondholders are generally happy to stretch things out. What is more, it isn't entirely clear how the costs of re-processing tens of thousands of mortgages will be allocated. Those costs could be "significant" said Andrew Sandler, a Washington, D.C., attorney who represents mortgage companies.
"This is sort of an extraordinary situation," said Debashish Chatterjee, a vice president for Moody's Investors Service who covers structured finance. By delaying foreclosures, "it means the subordinate bondholders don't get written down for a much longer period of time, and they keep getting payments."
Typically, mortgage servicers enter into contracts called pooling and servicing agreements with bondholders that spell out the servicers' obligations to manage the loans in the best interests of the investors. These agreements provide that the servicers be reimbursed by funds in the trust for all costs related to litigation and extra processing of foreclosures, provided they follow standard industry practices.
Servicing companies hope the reviews will be quick. At GMAC Mortgage, a unit of Ally Financial Inc., the vast majority of these affidavits will be resolved in the coming weeks and before the end of the year," a spokeswoman for the company said. A spokesman for J.P. Morgan Chase & Co. said the company's review process is expected to take "a few weeks."
But the problems could be magnified if the reviews uncover a lack of proper documentation or other substantive problems rather than simple procedural errors. The furor over servicer practices is also likely to trigger additional legal challenges from borrowers facing foreclosure and more judicial scrutiny, which could further slow the process and increase foreclosure costs.
The Association of Mortgage Investors, a trade association, has called on trustees, who oversee loan pools on behalf of investors, to demand that loans be repurchased by their originators if required documents are missing. Typically, sellers have 90 days to fix such problems or buy back the loan. The group has also asked trustees to audit and hold servicers accountable for any losses due to improper servicer practices.
"It's very hard to see how the servicers can avoid reimbursing the trusts for losses caused by taking short cuts," said David J. Grais, an attorney in New York who represents investors. Investors could press trustees to investigate servicer conduct, sue the servicers to recoup damages or replace a servicer, he said.
Write to Ruth Simon at ruth.simon@wsj.com and Robbie Whelan at robbie.whelan@wsj.com
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