Hedge funds profit, homeowners save

As millions of Americans struggle to hold on to their homes, Wall Street has found a way to make money from the mortgage mess.

Investment funds are buying billions of dollars' worth of home loans, discounted from the loans' original value. Then, in what might seem an act of charity, the funds are helping homeowners by reducing the size of the loans.

But as part of these deals, the mortgages are being refinanced through lenders that work with government agencies like the Federal Housing Administration (FHA). This enables the funds to pocket sizable profits by reselling new, government-insured loans to other federal agencies, which then bundle the mortgages into securities for sale to investors.

While homeowners save money, the arrangement shifts nearly all the risk for the loans to the federal government — and, ultimately, taxpayers — at a time when Americans are falling behind on their mortgage payments in record numbers.

For instance, a fund might offer to pay $40 million for a $100 million block of mortgages from a bank in distress. Then the fund could arrange to have some of those loans refinanced into mortgages backed by an agency like the FHA and then sold to an agency like Ginnie Mae, a government-owned corporation, which guarantees investors the timely payment of principal and interest on mortgage-backed securities backed by federally insured or guaranteed loans.

Reducing amounts

The trick is to persuade the homeowners to refinance those mortgages by offering to reduce the amounts the homeowners owe.

The profit comes when the refinancings reach more than the $40 million that the fund paid for the loans.

The strategy has created an unusual alliance between Wall Street funds that specialize in troubled investments — the industry calls them "vulture" funds — and homeowners.

But the transactions also add to the potential burden on government agencies, particularly the FHA, which has lately taken on an outsize role in the housing market and, some fear, may eventually need to be bailed out at taxpayer expense.

These new mortgage investors thrive in the shadows. Typically, the funds employ intermediaries to contact homeowners and arrange for mortgages to be refinanced.

Most in the dark

Homeowners often have no idea who their Wall Street benefactors are. Federal housing officials, too, are in the dark.

Policymakers have encouraged investors and banks to put more consumers into government-backed loans. The total value of these transactions from hedge funds is small compared with the overall housing market.

Housing experts warn that the financial players involved — the investment funds, their intermediaries and certain FHA approved lenders — have a financial incentive to put as many loans as possible into the government's hands.

Steven and Marisela Alva say they do not know who helped them with their mortgage. All they know is that they feel blessed.

Last December, the couple got a letter saying that a firm had purchased the mortgage on their home in Pico Rivera, Calif., from Chase Home Finance for less than its original value. "We want to share this discount with you," the letter said.

"I couldn't believe it," said Alva, a 62-year-old janitor and father of three. "I kept thinking to myself, 'Something is wrong, something is wrong. This sounds too good.' "

But it was true. The balance on the Alvas' mortgage was ultimately reduced to $314,000 from $440,000.

The firm behind the reduction remains a mystery. The Alvas' new loan, backed by the FHA, was made by Primary Residential Mortgage, a lender in Utah. But the letter came from a company called MCM Capital Partners.

In the letter, MCM said the loan was owned by something called MCMCap Homeowners' Advantage Trust III.

In Washington, D.C., mortgage funds are lobbying for policies that favor their investments, particularly mortgages held in securitized bundles.

They want more mortgage balances to be lowered, which might help mortgage bonds perform better. Big banks generally oppose such reductions, which lock in banks' losses on the loans.

In April, about a dozen investment firms formed a group called the Mortgage Investors Coalition to press their case. One investor who is speaking out is Wilbur L. Ross, who runs a fund that buys mortgages and owns a large mortgage-servicing company.

Ross said modifications that simply lower interest rates or lengthen the duration of a loan, as is typical in the government modification program, do not work well.

"They make a payment or two, but then one night the husband and wife will sit down at the table and say, 'Do we really want to make 140 monthly payments into a rat hole?' " Ross said.

The Fortress Investment Group, a New York hedge fund, is one of the firms at the forefront of picking through mortgages. Fortress created a $3 billion credit fund in 2008 partly to buy loans from banks like Citigroup, which were under pressure to purge loans to raise cash.

It is too early to know how the new loans will work.

David Stevens, the new commissioner of the FHA, said he was monitoring FHA lenders but did not have thorough information about which ones work with distressed investors. So far he has not seen a problem from loans coming from hedge funds.

"They're helping to protect people in their homes and they're refinancing people from a distressed situation."

But he acknowledged that funds have an incentive to push homeowners into federally guaranteed loans, since the investors get their money back as soon as they complete the refinancing.

Part of the risk may be determined by how the funds compensate the FHA lenders and whether the lenders are beholden to the funds for business.