For months politicians and consumer advocates have complained that mortgage servicers have been too slow to modify the mortgages of troubled borrowers, and their calls for the industry to reduce principal balances have been met with skepticism.

Now at least one servicer has begun forgiving some debt for a large number of homeowners - large enough to cost investors in the mortgage pools some money.

Last month investors in dozens of securitization deals serviced by Ocwen Financial Corp. received less interest than they expected. In many of the deals, even the top-rated classes of bonds were affected.

The West Palm Beach, Fla., servicer had modified hundreds of the loans backing the bonds by writing down the principal. Completing a modification entitles a servicer to get reimbursed for expenses it incurred while a loan was delinquent. That means the investors take a hit - though the incident has sparked a debate about which investors should bear the brunt of the losses.

David Gunter, Ocwen's chief financial officer and treasurer, said debt forgiveness is preferable to foreclosure. "The objective is to keep the cash flowing to investors," he said.

Wells Fargo & Co. is the bondholders' trustee on many of the deals serviced by Ocwen. Brian Bartlett, an executive vice president and head of corporate trust services at the San Francisco banking company, said Ocwen accounted for "the vast majority of loan modifications" among all the servicers of securitizations for which Wells acts as the trustee.

"Servicers like Ocwen are figuring out it's actually better and more lasting to do a principal reduction and it has a more permanent impact on someone's mortgage payment," Bartlett said.

The Office of the Comptroller of the Currency released a report this month that found industry efforts to modify loans had fallen far short of expectations. Comptroller John Dugan has called for the creation of a national reporting standard - to replace the current voluntary system - to better measure whether struggling borrowers are getting assistance.

"Up until now the reporting has been spotty," said Glenn Boyd, a director and head of U.S. securitization research at Barclays Capital's investment bank in New York.

Foreclosure-rescue legislation being considered on Capitol Hill calls for lenders and servicers to accept discounted payoffs on some loans. The idea has been called unrealistic.

In early May, Susan Barnes, a managing director of RMBS for Standard & Poor's, said at a Mortgage Bankers Association conference in Boston that servicers were having problems getting investors to "sign off on principal writedowns."

But Diane Pendley, a managing director in Fitch Ratings operational risk group, said last week that "principal forgiveness is becoming a more accepted type of loan modification."

In May, she said, "Ocwen had a much larger number of these modifications reported through this particular cycle than they had in prior cycles."

The sudden uptick caused a glitch at Wells Fargo, which says it could not determine from the information provided by Ocwen whether the modifications were principal writedowns - which typically would only affect subordinated bondholders - or interest rate reductions.

So Wells treated the loans as if their rates had been reduced; it lowered the interest payments to senior bondholders.

"Before last year, loan modifications weren't anything that anyone did, and now the preponderance of these is principal reductions," Bartlett said.

As a result of the snafu, Wells recently changed its reporting format so that servicers can indicate which types of modifications are being made and allocate losses accordingly.

Pendley said that when loans become delinquent, servicers often advance principal and interest to bondholders until the loans are "brought current by way of modification" or liquidated. They may also front the cash for property inspections and appraisals during this period.

"Ocwen has a right to these funds," Pendley said. "They are not getting any additional payback."

One problem for servicers and investors has been that the pooling and servicing agreements do not specify precisely enough how losses to investors should be allocated.

"When these contracts were written, there wasn't the contemplation that there would be the number of modifications that we're seeing," Ms. Pendley said.

Joseph Astorina, a director in U.S. securitization research at Barclays Capital, said there is "great ambiguity" in how trustees interpret the rules of such agreements and it is unclear whether investors in triple-A-rated mortgage securities could suffer additional interest shortfalls.

In a note to clients last week, Astorina wrote that mortgage principal reductions "are becoming a more prevalent form of loan modification" that can result "in an immediate loss" to bondholders.

His colleague, Boyd, said that a loan typically has to be liquidated for a securitization trust to take a loss, but pooling and servicing agreements are not clear on what to do about a principal writedown.

"People noticed this last month because Ocwen had done a large number of loan mods and this showed up as interest rate shortfalls on a lot of bonds," Boyd said.

"When you dig into other deals" where Ocwen was the servicer, "you find out this was going back to the beginning of the year, with interest rate shortfalls resulting from an interpretation."

Vincent Barberio, a managing director at Fitch, said that if there is an interest shortfall in one month, it can be made up in subsequent months if excess funds are available.

Bruce Marks, the chief executive officer of Neighborhood Assistance Corp. of America, sounded surprised to hear that Ocwen has been forgiving some debt.

He said his Boston nonprofit has worked with the company to restructure 500 to 1,000 loans and "not one of them has had a principal reduction."

In 2004, Ocwen entered into a supervisory agreement with the Office of Thrift Supervision to overhaul its servicing practices, which had been criticized by consumer activists. The company dropped its thrift charter the following year.

Also in 2004, numerous borrower lawsuits against Ocwen were consolidated in the U.S. District Court for the Northern District of Illinois. The suits accuse the company of charging borrowers improper or unnecessary fees, misapplying payments or failing to post them on time, and improperly treating borrowers in default. The court has found in Ocwen's favor on some issues, but as of May 8 the case was still pending.

Of 91 deals sampled by Barclays Capital, 39 had significant interest shortfalls "related to Ocwen's loan modifications and reimbursements of servicer advances," and 10 had interest shortfalls below senior classes.

"This is of growing concern to investors because loan modifications have been growing, and that could be problematic," Astorina said.

Paul Koches, a senior vice president and the general counsel at Ocwen, said the company has been "minimizing losses for the benefit of mortgage-backed securities ... investors."

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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