Housing and Urban Development Secretary Shaun Donovan mostly confirmed that private-label mortgage-backed securities investors, not banks or servicers, will end up shouldering the cost of much of the imminent foreclosure fraud settlement despite the risk of litigation from investors who are likely to challenge the forced losses on their securities in court.

On a small conference call for progressive media, Donovan claimed that the money available in the settlement for principal reduction for underwater borrowers would actually come to $35-$40 billion, over double the $17 billion in nominal principal reduction that has been widely reported. The HUD Secretary said that this represented an “important first step” of principal reduction. “Relative to the $700 billion in negative equity in the country, it’s not anywhere near adequate, but it’s an important first step,” Donovan said, one which will be augmented with by “jump-starting” other voluntary principal reduction among servicers if it is found to be successful in preventing foreclosures, and other claims, including from the Residential Mortgage Backed Securities working group co-chaired by New York Attorney General Eric Schneiderman. “One reason I’ve been a strong partner (on the working group) is the opportunity to get large-scale relief for families that have been victims of the crisis,” Donovan added.

But how exactly does Donovan get to $35-$40 billion when the reports all claim $17 billion (as well as $8 billion in various penalties and checks for wrongful foreclosures, adding up to a $25 billion settlement)? He said that the topline numbers have always reflected the settlement with the five largest servicers. When you throw in the other 9 servicers who have been in discussions on the settlement, the level rises to more like $30 billion. Furthermore, “not all write-downs are created equal” in the settlement, Donovan said. The $17 billion on principal reduction always reflected “credits,” a number that the servicers would have to hit to comply with the settlement terms. Some of the credits are not dollar-for-dollar. For instance, principal reduction on loans that are over 175% LTV (loan-to-value ratio) would not get full credit because it would be a “reduction” on a house that will probably go into foreclosure anyway. “If a servicer is writing down a current first-lien mortgage, that has more value than a second lien 180 days delinquent,” Donovan gave by way of a separate example.

When you add all this up, Donovan asserted, “For every dollar of credit, we’ll be getting on average $2 or more of principal reduction. That’s how you get from $17 billion to $35-$40 billion.”

One example of this that has been reported was revealed by Shahien Nasiripour in the Financial Times. Under the terms of the settlement, servicers would get credit for reducing principal on loans they don’t own.

Investors in US home mortgage bonds may have to swallow losses as part of a wide-ranging settlement being discussed between leading banks and the Obama administration to resolve allegations of foreclosure misdeeds, people familiar with the matter said.

Participants in the discussions cautioned that a final agreement remains weeks away and that the terms being discussed could change. However, they said it is likely banks would be able to reduce loan principal on mortgages owned by investors through mortgage-backed bonds [...]

Officials have discussed giving the banks credit to the tune of roughly 50 cents on the dollar for cutting the principal on mortgages owned by bond investors.

Think about how this lines up. Principal reductions for private-label MBS would end up getting 50 cents on the dollar in credit. Donovan claims the principal reduction will end up twice as large. That’s an exact match. So pension funds and other investors would pay the cost of a lot of this settlement; of course the banks would rather pay fines with someone else’s money.

This has already caused an uproar on Wall Street, with securities investors not wanting to get stuck paying for the banks’ misdeeds. Some trade groups for mortgage investors have criticized the deal, and the powerful group SIMFA (The Securities Industry and Financial Markets Association) only stopped short of that because of pushback from their leadership. SIMFA has been criticized by many on Wall Street for representing banks rather than investors, and their squelching of criticism of the settlement deal plays into that. Sen. Sherrod Brown has also criticized this aspect of the deal, saying that “Teachers, first responders, law enforcement, and other pensioners and retirees should not be penalized for wrongdoing by Wall Street.”

Questioned about this, Donovan actually sounded happy. “The fact that there are those concerns tells me you will see a significant amount of principal reduction, not only on loans in (the banks’) portfolios but in private label securities (PLS) loans,” Donovan said. “That’s a very good thing from my perspective. I will confirm that we expect a substantial amount of principal reduction in private label securities loans.”

But one of the reasons we haven’t seen a lot of principal reduction in those PLS loans, even though many investors welcome principal reduction that would reduce their overall losses (the servicers often hide behind their hands being tied, because they have a financial incentive to foreclose rather than reduce principal), is the risk of litigation from the investors themselves. There’s a good chance investors would argue that a deal like this represents an unconstitutional taking from them without fair compensation. Bill Frey of Greenwich Financial has already had discussions among investors about legal action.

Donovan acknowledged that this has slowed down PLS write-downs in the recent past. And he offered up some extremely weak possibilities to get around this. “There’s nothing to stand in the way of the servicer deciding to pay a portion of the write-down for PLS investors to ensure it goes forward with no lawsuits,” Donovan said. There’s nothing to stand in the way of me buying a unicorn either, I guess, but I’m as likely to do that as a servicer is to pay its investors out. It also wouldn’t solve the problem. Donovan cited the $8.5 billion BofA settlement with its investors, where they in return got the right to service the loans as they saw fit. But that settlement isn’t a done deal, it’s being contested in court by a bunch of investors who said they weren’t privy to the settlement, and even Schneiderman and Delaware AG Beau Biden have stepped in to block that deal on behalf of investors in their states. That the HUD Secretary would use that flawed deal which hasn’t gone forward as a model about how to solve problems with this aspect of the settlement is pretty surprising.

Why should ordinary non-investors care about this issue? First of all, if investors sue successfully, it could blow up the entire settlement and leave homeowners with nothing. Second, if it goes through, investors like pension funds could foot a substantial part of the bill for a fraud perpetrated by the banks, leading to yet another frustrated lack of accountability for the financial crisis.

I will have more from this very revealing interview with Donovan in future posts over the weekend.