June 6 (Bloomberg) -- Dan Castro favors cutting the amount of money that some delinquent homeowners owe him so they can qualify for government help and avoid foreclosure. He's not sure other mortgage-backed securities investors feel the same.

For legislation being considered by Congress to work, they would have to.

``You'll never get everybody on board,'' said Castro, chief risk officer for New York-based Huxley Capital Management.

Proposals advancing in the Senate and House of Representatives would call for the federal government to insure as much as $300 billion in refinanced mortgages, potentially saving up to 2 million borrowers from foreclosure, according to one of the sponsors, Representative Barney Frank. Declining home prices will mean that one-third of those borrowers will default again, prolonging the deepest housing crisis since the 1930s, said Michael Carliner, former economist at the National Association of Home Builders in Washington.

``Clearly, if you recast the mortgage lower and it still goes bad, you're just prolonging the agony and making the loss severity worse than it is now,'' said Castro, formerly chief credit officer at GSC Group and managing director of structured finance research at Merrill Lynch & Co.

In addition to counting on investors to cut the principal they are owed, the bills, backed by Senator Christopher Dodd, a Connecticut Democrat, and Frank, a Massachusetts Democrat, would require borrowers to keep making their monthly payments even as they are given an incentive to stop. Holders of second-lien mortgages also would have to consent to taking losses of more than 99 percent.

Conflicting Interests

``We've never solved all the conflicting interests,'' said Allen Fishbein, director of housing and credit policy at the Washington-based Consumer Federation of America. ``That has stymied programs designed to help.''

Reducing the amount of money borrowers owe would mean that investors would lock in their losses, something many of them have so far been unwilling to do, said Paul Kasriel, chief economist for Northern Trust Corp. in Chicago.

Changing terms of the agreement between the borrower and those who securitize the transactions may scare away investors, drying up the biggest source of mortgage funding and making it harder for lenders to issue home loans, said Tom Deutsch, deputy executive director of the Washington-based American Securitization Forum, which represents the securities industry.

Credit Crisis

``If you change contracts, you call into question whether future agreements will be fulfilled,'' Deutsch said. ``If investors don't believe contracts will be fairly upheld, the credit crisis in America will extend much, much longer than it would.''

More than moral pressure will be used to persuade investors to reduce the principal, said Frank, chairman of the House Financial Services Committee, in an interview last week.

``If this passes and is signed by the president, you have the House and Senate, the Secretary of the Treasury, the head of the Federal Reserve, urging them to do this, and they do, after all, want other things from us and I would think it would be in their interests to promote a cooperative relationship,'' Frank said. ``These are people who have to worry about what the legislative and regulatory framework is going forward. And if this kind of voluntary effort doesn't work, then the likelihood is there will be tougher legislation going forward.''

`Best Interest'

The cost of foreclosure -- an estimated 35 percent of the value of the home, according to the Association of Community Organizations for Reform Now, or ACORN, a non-profit homeowner advocacy group -- is one reason lenders and investors will volunteer to reduce the amount of money borrowers owe, Dodd said.

``Participation is not required, although industry experts agree that avoiding foreclosure is almost always in the best interest of not only homeowners and their neighbors, but also investors and lenders,'' Dodd said in an e-mailed response to a request for comment.

About 90 percent of subprime loans have been bundled into securities, according to Inside Mortgage Finance, a Bethesda, Maryland-based industry newsletter. Subprime mortgages were available to borrowers with bad or incomplete credit, who now are behind on their payments at more than five times the rate of prime mortgage borrowers, according to the Washington-based Mortgage Bankers Association.

The government set a precedent with the Fed's guarantee of collateral in the JPMorgan Chase & Co. takeover of New York-based securities firm Bear Stearns Cos. and it would be unfair to deny homeowners a similar break, said Ronald Peltier, chief executive officer of Minneapolis-based HomeServices of America Inc., the real estate unit of Warren Buffett's Berkshire Hathaway Inc.

Bear Precedent

``Bear Stearns was a, quote unquote, sophisticated financial entity, so it's pretty disingenuous to think that there isn't serious attention given to the consumer who clearly doesn't understand the complexities that surround financial markets,'' Peltier said.

The same concern over acknowledging losses extends to second- lien mortgage holders, who, following a foreclosure sale, receive returns on their investments only in the event there is money left after first-lien mortgage holders get paid, said Grant Stern, owner of Morningside Mortgage Corp. in Miami Beach, Florida.

``Second-mortgage holders are already taking big hits, 80 to 95 percent losses, and they're looking to recover whatever they can,'' Stern said. ``They are going to be a problem. For them, there's no recourse. It would be pretty onerous to negotiate with them.''

Senate Vote

Bonds made up of second mortgages have fallen so steeply in value that Standard & Poor's, a unit of New York-based McGraw-Hill Cos., said May 1 it would stop rating new bonds of second mortgages because they have become too difficult to assess.

Under the proposed legislation, second-lien holders could get up to 1 percent of their investment back or take their share of profits from the future sale of the home, Frank said.

``Many of them would probably find it reasonable to make a deal as opposed to foreclosure,'' Frank said. ``Foreclosure wipes them out altogether.''

Frank's measure was approved, 266-154, by the U.S. House of Representatives on May 7. A similar bill passed the Senate Committee on Banking, Housing and Urban Affairs, of which Dodd is chairman, 19-2, on May 20.

Senator Bob Corker, a member of the committee that approved the Dodd measure, said the proposal made sure that investors weren't forced into changing loan terms.

Market's Fate

``What that's going to mean is there will be limited numbers of mortgages under this bill that will be refinanced,'' Corker, a Tennessee Republican, said in an interview. ``This limited approach is fair. You only do it if everybody agrees it's the right thing to do. I think certainly it's going to have a tremendously limiting factor, but I think that's appropriate.''

For the housing market to recover, borrowers who can't afford their homes must be replaced with homeowners who can, said Stuart Saft, a real estate lawyer and partner in the New York firm Dewey & Leboeuf LLP.

``This legislation will prop up the housing market and continue to make homeownership unaffordable to people who haven't gotten loaded down with debt,'' Saft said. ``It's not the end of the world if people lose their homes. Many didn't have equity in the homes. You have borrowers sitting there saying if we don't do anything at all the government will come and bail us out. By keeping them in place, all we're doing is continuing the housing crisis.''

Price Declines

Amado Lopez bought a house in July 2006, then couldn't sell the one he was living in. He's worked extra hours to stay current on two mortgages.

``We're struggling to make payments and we don't get any relief, but somebody who doesn't make the payments gets the relief?'' said Lopez, 43, who owns and runs a medical diagnostic center in West Palm Beach, Florida, an area where foreclosure filings have more than doubled in the last year, according to RealtyTrac Inc. ``Last night I worked until 3 in the morning. I could use some help, too.''

Home prices have dropped 12 percent from the highs of July 2006, when Lopez bought his new home, according to the Chicago- based National Association of Realtors. Prices will continue to fall, resulting in a peak-to-trough national decline of about 25 percent, according to economists Michelle Meyer and Ethan Harris at Lehman Brothers Holdings Inc. in New York.

Almost a third of existing home sales this year will be of foreclosed properties, the Lehman economists said in a May 29 report. Without anti-foreclosure legislation, 1.4 million homeowners will lose their houses to foreclosure in 2009; the Frank-Dodd bills may cut that number by about 33 percent, they said.

Jim Bunning

Senator Jim Bunning, a Republican from Kentucky who also is a member of the committee that approved the Dodd measure, said the proposals send the wrong message to borrowers.

``It tells people who acted responsibly they were fools for living within their means, and those who acted irresponsibly to make even bigger bets next time,'' Bunning said in an e-mailed response to a request for comment. ``It is not fair and I can't blame someone for being upset when their neighbor who drained all the equity in their home to buy a new car and go on vacation has that debt forgiven, gets a lower payment and equity back in the home, and is not even asked to make any sacrifices such as selling the car or getting a second job.''

Possible legislation may amount to little more than election- year posturing, said Castro of Huxley Capital Management.

``I hate to be cynical, but if it sounds good, the politicians will do it no matter how effective it turns out to be,'' he said.

To contact the reporter on this story: Bob Ivry in New York at bivry@bloomberg.net.

Last Updated: June 6, 2008 00:02 EDT