July 23 (Bloomberg) -- The government waded into a fight between different classes of mortgage-bond investors with guidance that benefits owners of the highest-ranking securities at the expense of other debt holders.

Mortgage servicers reworking loans under the U.S. modification program should treat as a loss any part of borrowers’ debt exempted from interest and principal payments when passing on funds to bond investors, according to an update to guidance posted yesterday on a government Web site. Partial forbearance is one tactic for lowering homeowners’ bills.

The $75 billion “Home Affordable” program is intended to aid 3 million to 4 million homeowners and curb the soaring U.S. foreclosures roiling the economy. Not accounting for forborne principal, which may include amounts that exceed the current value of properties, as a loss would boost payments to junior- ranking debt in the $1.8 trillion “non-agency” market with cash that would otherwise go to senior bond investors.

“This was one of a number of very, very important issues and I think this largely settles it,” Laurie Goodman, an analyst in New York at Amherst Securities Group, said in a telephone interview today.

Defaults Assumed

In the view of senior bondholders, “it is not good faith and fair dealing to pay out funds based on a distribution schedule that is predicated on an assumption that the assets will support the liabilities, when in fact all parties to the securitization know that is not the case,” according to a paper published last month by the American Securitization Forum, a New York-based trade group.

The stance partly reflects the likelihood that some borrowers will default on their mortgages later, hurting junior holders then.

The guidance “matches common sense with sound accounting principles,” said Micah Green, a partner at Patton Boggs LLP, a Washington law firm that represents a mortgage-investor group of 11 money managers with $200 billion of assets under management. Forborne debt might not be paid out to investors for 40 years, “so it has very little economic value,” he said.

Under President Barack Obama’s modification program -- which offers taxpayer subsidies to lenders, bond investors, loan servicers and homeowners -- servicers are directed to rework borrowers’ mortgages through a variety of means so their housing payments equal 31 percent or less of their incomes.

Timing of Loss

Principal forbearance, which is called for if lowering interest rates or extending loan terms isn’t sufficient, means that no interest is charged on some of the debt. Repayment of that amount isn’t required until maturity of the mortgage or sale of the property.

“Subordinate holders believe that, because forborne principal is still owed by the borrower, a loss should not be taken until the loan is actually liquidated,” according to the trade group’s paper.

In the update to a “frequently asked questions” document, the government said that servicers, which manage outstanding mortgages for bond investors, should follow the treatment called for under Federal Deposit Insurance Corp.’s mortgage- modification protocols created last year.

“Principal forbearance should be passed through as a write-off of principal to the securitization trust, unless directed otherwise by the applicable pooling and servicing agreement or trust agreement,” the guidance said.

Price by Class

Non-agency mortgage securities, which lack government backing, were created by slicing pools of loans into different classes of bonds paid in varying priorities with the principal and interest received from the underlying debt.

With many junior securities trading at pennies on the dollar, typical prices for the most-senior bonds backed by so- called option adjustable-rate mortgages last week were 42 cents on the dollar, according to a Barclays Capital report.

Most modifications of option ARMs, whose minimum payments fall below the interest owed by borrowers and create growing balances, will probably involve forbearance, said Goodman, the Amherst Securities analyst.

Some consumer advocates and bond investors including Fortress Investment Group say forgiveness of mortgage principal, rather than forbearance, should be the strategy pursued by the Obama administration. With forbearance, borrowers might be more likely to default later because they may still owe more than their homes are worth.

‘Re-Default’ Risk

“By not addressing negative equity, homeowners are trapped in a mortgage that cannot be refinanced and a house that cannot be sold,” Curtis Glovier, a managing director at New York-based Fortress, told Congress on July 16, speaking on behalf of the Mortgage Investors Coalition, the group represented by Green. “There could be a meaningful risk of a re-default.”

Some types of servicers believe mortgage-bond trustees, which act as administrators, may be in charge of deciding the treatment for principal forbearance, while trustees say it is servicers’ “responsibility” to make that determination, according to the American Securitization Forum paper.

The guidance to servicers will likely settle the issue, Goodman said.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net or

Last Updated: July 23, 2009 18:21 EDT