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Fed bailout tackles contractor conflicts, tranche wars.

The Emergency Economic Stabilization Act of 2008, often called the "bailout bill," establishes the federal Troubled Asset Relief Program. The Secretary of the Treasury is authorized to buy or insure up to $700 billion of residential and commercial mortgage loans, mortgage backed securities, and other related assets, originated before March 14, 2008, that the Secretary of the Treasury deems to be "troubled."

The Treasury Secretary is given very broad discretion to issue regulations, defining the scope of this program, by Nov. 17, 2008. In many ways, the program, as enacted by Congress, is merely in skeletal form, and the Treasury Secretary has the power to fill in many details.

For example, the Treasury Secretary has issued interim guidelines to restrict conflicts of interest of contractors participating in the program. These guidelines require each contractor to make full disclosure of actual and potential conflicts of interest, relating not only to such contractor, but also to its affiliates, consultants, and subcontractors, and potentially even its employees.

If there are any such conflicts, the contractor must propose a "mitigation plan." Since practically every experienced contractor could be expected to have some conflicts of interest, the process of investigating and disclosing such conflicts could be very burdensome, and Treasury may be required to make difficult decisions regarding which contractors are conflicted. Treasury may also require agreements, with conflict of interest and non-disclosure provisions, from not only a contractor but also its subcontractors and employees. Each contractor must also disclose whether it owes a fiduciary duty to the U.S. Treasury, which will probably induce most contractors to assume such duty.

Congress clearly expects Treasury to agree to many loan modifications in order to help struggling homeowners. However, a major obstacle to any loan modification affecting a pool of mortgage loans or securities is that it may affect the investors in such pool unequally. The most junior tranche or class may object to any loan modification that would impair its recovery of principal, but the more senior tranches may be willing to sacrifice the interests of the junior tranche for the sake of restoring current payments to senior tranches. This is called "tranche" warfare.

The Act provides that the servicer of a pool of residential mortgages is entitled to take such action as will benefit all investors as a whole, rather than any particular class, subject to any conflicting provision in the applicable pooling and servicing agreement which obligates the servicer to act for the investors.

Nonetheless, servicers of pools of mortgage loans or securities will probably still refuse to enter into a loan modification unless it has been approved by the investors in such pool, and such investor consent is unlikely to be granted on a wide scale. While many pooling and servicing agreements do provide limited flexibility to enter into loan modifications, these agreements will probably not permit the substantial loan concessions that Congress is hoping will be granted to struggling homeowners. Many pooling and servicing agreements require the consent of each investor to any modification of the underlying mortgage loans that would change the scheduled payments to such investor. This is consistent with the Trust Indenture Act of 1939.

Even if the U.S. Treasury was willing to absorb all cash flow deficits in a given pool of mortgage loans, it could generally not enter into any significant loan modification affecting such pool unless it acquired at least two-thirds of the mortgage securities secured by such pool, since the typical form of pooling and servicing agreement requires such two-thirds consent.

The required consents for a given loan modification will be even more difficult to obtain if(I) a pool of mortgage securities includes interests in other pools of mortgage loans, (2) any homeowner has more than one mortgage loan (each loan is usually securitized separately and included in a separate pool), (3) any homeowner has private mortgage insurance, which is generally terminated by a loan modification, (4) any net interest margin securities with respect to any pool (representing the residual or "equity" interest in such pool) have been insured by an insurer, since such insurer must also generally consent to any amendment to the pooling and servicing agreement, and (5) any loan modifications are significant enough to jeopardize the tax-free REMIC status of the pool.

BY BROOK BOYD, ATTORNEY, WINDELS MARX LANE & MITTENDORF, LLP
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Title Annotation:INSIDER'S OUTLOOK
Comment:Fed bailout tackles contractor conflicts, tranche wars.(INSIDER'S OUTLOOK)
Author:Boyd, Brook
Publication:Real Estate Weekly
Date:Oct 15, 2008
Words:722
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