By Fortune Editors
July 26, 2011

By Abigail Field, contributor

FORTUNE — Investors in mortgage-backed securities who got cleaned out during the housing bust aren’t going to take their losses lying down. The first act of investor revolt was organized by Kathy Patrick, a little-known litigator who led her clients to a proposed $8.5 billion settlement from Bank of America and Bank of New York Mellon. The second act began on July 21, and it attempts a far more transformational outcome than the BofA/BNY deal.

Last week, the Association of Mortgage Investors (AMI) sent a firm but polite letter to all the “major trustees” for mortgage-backed securities, inviting the trustees to do their jobs and offering to work with them if the trustees did. AMI did not respond to a request for comment. Although the letter’s recipients are unknown, the largest trustees are JPMorgan Chase (JPM), Deutsche Bank (DB), US Bank (USB), Wells Fargo (WFC) and Bank of New York (BK). Backing up the invitation was the implicit threat that AMI would sue the trustees for “look[ing] the other way and remain[ing] uninvolved,” even as widespread and profound violations of the securities’ contracts became known.

Specifically, AMI accuses the trustees of failing to force mortgage originators and securitizers into buying back all the loans that weren’t up to the promised standards or even giving investors sufficient information about the loans. AMI also claims that mortgage servicers were flagrantly violating the securitization contracts, and the trustees were obligated to fire them if the servicers didn’t clean up their acts. Although AMI backs its charges with 10 pages of footnoted descriptions, the letter wasn’t a formal demand intended to clear the way for near-term litigation, as the Patrick letter was.

Instead, AMI maintains a big-picture focus and claims to pursue lofty goals. AMI wants “to develop and implement mortgage and housing policy that keeps homeowners in their homes while promoting the availability of financing for home purchases.” To do that, AMI says, all the issues with the 2005-2008 vintage private-label mortgage-backed securities have to be resolved in an investor-friendly way. Only then can the private-label securitization market get going again, which is essential for a housing recovery, according to AMI. To that end, AMI invites the trustees to work with it to develop best practices to deal with the lousy MBS. AMI expects to finish developing such practices next quarter.

Will the banks play ball?

Since the letter wasn’t a formal threat of imminent litigation, why should the trustees pay attention and join forces with AMI? For starters, the more the trustees know and yet remain on the sidelines, the more their potential liability grows. Second, AMI reminded the Trustees that if they cooperate in enforcing the securities’ contracts, the investors had to pay the Trustees’ legal and other costs. Third, AMI claims to represent investors with “approximately $300 billion of MBS assets under management, including a significant portion of the nation‘s first lien mortgages residing in private label RMBS.” That’s a huge number, but it’s hard to parse its exact meaning. To force trustees to act, shareholders typically have to hold 25% of the voting rights in any given trust. Since Patrick’s group of investors claimed to be 25% owners of 115 trusts while owning “only” $16.5 billion in assets, surely the AMI’s holdings of nearly 20 times that amount means it can speak on behalf of many more trusts. How many trusts, and which ones, is notably missing from the letter.

So are any trustees going to play ball? Maybe. But they all have potentially deep conflicts of interest. Take JPMorgan Chase. Chase is one of the largest mortgage servicers, it originated a lot of risky loans, and it swallowed Bear Stearns. Chase would have a lot of potential liability for those actions if the effort AMI is trying to organize succeeds. The bank also faces potential liability by not responding to AMI, but how does that trustee liability to compare to what Chase would presumably face on the originator, securitizer and servicer sides?

Do such conflicts of interest have an impact on trustees’ willingness to fight for investors? Looking at the Bank of New York/BofA proposed deal, it sure seems so. The core conflict between BNY’s interests and the investors’ is simply that BNY is a big trustee with one massive client: Bank of America. Surely BofA would start using a different trustee if BNY really went after BofA on behalf of the investors. Investors objecting to the BNY/BofA deal have raised other serious concerns too. Given the conflicts, the paltry sum of $8.5 billion for claims by over 500 securitized BNY/Countrywide trusts is more understandable.

Chase declined to comment through its spokesman Thomas Kelly, as did Bank of New York through spokesman Kevin Heine. US Bank and Deutsche Bank did not return requests for comment.

One thing’s for certain: AMI’s letters are only the beginning, and the second act of investor revolt will take weeks if not months to develop. AMI signaled it wouldn’t be committing to a course of action until at least the third quarter, when it expects to finish figuring out precisely how it wants to handle the situation. Which banks cooperate and which don’t will say a lot about their internal liability calculus.

 

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