If banks were looking for a palatable trade-off in state and federal regulators' plan to revamp mortgage servicing practices, they didn't find it.

In the view of banking officials, the proposal's compliance costs will be exorbitant and they won't be shielded from exposure to liabilities.

They argue that the largest mortgage servicers would bear the brunt of the cost of defaulted loans by reducing borrowers' principal and extinguishing second liens. That, they say, would pinch capital.

Though many of the provisions of the 27-page plan are a rehash of existing law, attorneys for the servicing industry say overall it is inherently unfair.

"These costs were not anticipated by anybody and therefore they were not captured anywhere, so a lot of this is about who pays," said Ken Kohler, a partner in Morrison & Foerster's banking practice.

Meanwhile, servicers and investors said it is unclear whether state regulators, with the eventual aid of the Consumer Financial Protection Bureau (CFPB), have the ability to enforce some of the requirements. A few state attorneys general have said that they are being pressured into agreeing to a settlement without being told what they would be giving up in terms of releasing servicers from potential claims.

It also is unclear whether a settlement would override existing contracts with investors or with Fannie Mae and Freddie Mac.

For nearly three years now the industry has largely blamed the glacial pace of loan modifications on investors. Servicers have argued that the pooling and servicing agreements governing securitizations prohibit certain practices such as reducing a borrower's principal.

Terry Laughlin, the Bank of America Corp. executive recently appointed to clean up the bank's legacy mortgage operations, said at an investor day conference Tuesday that reducing principal will not help many borrowers who do not have enough income to stay in their homes.

"Principal reduction is not a panacea here," Laughlin said.

Representatives of Citigroup, JPMorgan Chase and Wells Fargo declined to comment.

Bankers are particularly concerned that a provision of the agreement would further expose them to liability. The last sentence of the proposal states that "a material violation of this agreement constitutes an unfair and deceptive trade practice and a breach of duty of good faith and fair dealing."

If a servicer violated any provision of the proposal, it could be prosecuted under the Federal Trade Commission's law governing unfair and deceptive acts or practices.

Bankers are concerned the settlement would hurt them in existing civil cases and open them up to future liability.

When asked Monday whether the settlement would hurt banks in existing civil cases, Tom Miller, the Iowa attorney general, said: "We don't have the authority to cut off liability for private parties, so we can't do that. But I think that overall for the banks to resolve these, there's a lot of value for them settling these cases and the issues with us."

Only a few parties seemed happy with the proposal.

"I'm thrilled about the principal modifications, and I'm thrilled about the disclosure of the default and foreclosure-related fees," said Laurie Goodman, an analyst with Amherst Securities Group and a frequent critic of servicer performance.

But Josh Rosner, a managing director at Graham Fisher & Co., said regulators appeared to be capitulating without first assessing which servicers had violated laws, such as the pyramiding of foreclosure fees. Rosner said there is nothing in the document that "precludes inappropriate costs" from being passed on to investors.

Goodman dismissed the possibility that investors would stand in the way of a settlement because the savings would lower investors' eventual loss severities in the case of foreclosure.

Bill Garland, a senior vice president of servicing portfolio solutions at ISGN, a mortgage technology firm, said the proposal does not bode well for a quick resolution to foreclosure problems and the stability of housing prices.

"A major concern for the industry, is that every borrower is going to line up for a principal reduction whether they need it or not," Garland said.

Cheyenne Hopkins, Jeff Horwitz and Sara Lepro contributed to this story.

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