In the first major legal challenge to mass loan modification programs, bondholders have filed a lawsuit claiming Countrywide Financial Corp. cannot change mortgage terms without their permission.

The suit, filed Monday in the New York State Supreme Court, could derail the modification efforts Bank of America Corp. agreed to make in October when it settled predatory lending allegations against Countrywide with the attorneys general of 15 states.

William Frey, the lead plaintiff, said investor contracts with Countrywide do not allow the lender to modify the terms of any loans, even those in default, unless it purchases the notes out of a securitized trust at par value.

By offering to modify significant numbers of defaulted mortgages, Countrywide is trying to pass on to investors the bad debt that should rightfully be the lender's responsibility, said Frey, the principal and chief executive of Greenwich Financial Services, a broker-dealer that manages securitization trusts on behalf of bond investors. "Investors want this resolved according to the contracts," he said.

J. Bruce Boisture, the managing partner of Grais & Ellsworth , which is representing Greenwich Financial Services, agreed that if Countrywide modified loan terms, it would have to buy the loans out of the trusts first.

"Modifications may indeed be a great idea. The only question here is who is going to pay for it," he said. "And our position is that bondholders are not going to pay for these modifications. Countrywide needs to pay for them."

The suit alleges that either Countrywide Home Loans or Countrywide Servicing must purchase all loans the lender modifies from any of 374 securitization trusts. Boisture said he is seeking class-action status for the suit.

Countrywide said that the suit is "an unlawful effort to assert rights of the trusts," and that the modification program would benefit investors. "This program proactively addresses a potential for far greater investor losses that would be realized if not for us undertaking modifications. No one benefits if we allow these homeowners to advance toward" foreclosure."

Frey said servicers typically advance principal and interest payments to investors on behalf of defaulted and foreclosed borrowers until a property gets sold. He argued that Countrywide must continue to pay its investors until seized properties are sold, even if it is not receiving loan payments.

Modifying the loans means that the investors' payments would be reduced, most likely sooner than a home could be seized and sold.

Boisture said Countrywide and B of A would be liable for roughly $80 billion of payments to the trusts, according to the agreement to modify 400,000 loans with an average unpaid principal balance of roughly $200,000.

When the settlement agreement was announced, B of A said it had been given "delegated authority" to modify 88% of the loans that it did not own and that had been pooled into mortgage-backed securities. A Countrywide executive said last month that its servicing group had been reaching out to the investors who had not given their approval to perform modifications.

Frey said thousands of investors would be affected by B of A's mass modifications, including public pension funds, the Federal Home Loan banks, and college endowments.

Investors have no objections to the fact that there was a settlement, he said, but they should not have to pay for it. "If you go speeding in a car, do you get to cut a deal with a cop that allows the passenger of another car pay the fine?"

Frey estimated that $2 trillion to $3 trillion of whole loan securities are "in deep trouble," and that bondholders need tohave a voice in how the deals to modify loans are worked out.

Frey said he tried to contact Countrywide's servicing unit, but his calls were never returned. "I would hope that the servicers learn that they have contractual obligations, and that investors are watching, and they expect those obligations to be honored."

B of A put an $8.4 billion cost estimate on the modification program in October and said the costs for modifying the loans it owns had already been estimated as part of the Countrywide acquisition. It did not estimate the cost of modifications that would be covered by bondholders.
The issue of who will pay for modified loans has become a contentious one. House Financial Services Committee Chairman Barney Frank has said he would consider new procedures to speed up modifications.

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