An easy tweak to pooling and servicing agreements would allow short sales on defaulted mortgage notes in mortgage-backed securities trusts, according to a white paper distributed by American Home Mortgage Servicing. Short sales from MBS issues is the key to unlocking principal reduction modifications, according to the paper. Jordan Dorchuck, executive vice president and chief legal officer of the Texas-based mortgage servicing firm, said many PSAs prohibit servicers from selling loans out of trusts prior to liquidation through foreclosure. Dorchuck wrote the white paper with Jim Lockhart, vice chairman of WL Ross & Co., and Pete Mills, managing director of Mortgage Banking Initiatives Inc. The PSAs don’t authorize these distressed mortgage loan sales because loss of accounting sale treatment would have resulted in potentially financially costly results for the securitization sponsors, but a change in accounting rules last year no longer constrains servicers from selling distressed notes out of securitization trusts, the paper says. The authors said the Treasury Department and home loan industry need to consider principal reductions and increase the number of short sales on defaulted loans within MBS to lessen foreclosures and reinvigorate the market. Short sales “provide an additional tool to offer deeply distressed borrowers a last chance to avoid foreclosure.” The authors said millions of homeowners with loans that have been bundled as collateral for private-label, residential mortgage-backed securities aren’t able to get a modification for various reasons. Many borrowers don’t qualify for the federal government’s Home Affordable Modification Program or similar program because it would require a steep principal reduction that would result in the mod stressing or failing the net-present-value test. Also, a lot of contracts governing MBS include caps on the number of loans eligible for modification, prohibit certain loan mod options such as principal reduction, as well as banning the sale of notes from trusts, according to the authors. While there are a substantial number of homeowners underwater on their mortgage — where they owe more than the property is worth — servicers are reluctant “to reduce principal for fear of investor dissatisfaction and out of concern for moral hazard.” Dorchuck, Lockhart and Mills also said the massive volume of distressed properties interferes with servicers’ ability modify loans. “Removing these loans from securitization trusts at NPV positive prices, and allowing private sector distressed asset purchasers to compete for and acquire the loans, should provide a material benefit to borrowers by giving them the one last clear chance that HAMP was intended to provide, but appears unable to deliver to many homeowners,” they said. “From the MBS investor perspective, market prices of their securities already reflect large foreclosure losses. Short sales of mortgage loans should reduce those expected losses and achieve ‘finality,’ quickly. Hundreds of thousands of homeowners could potentially be helped with affordable loan modifications if they included responsible principal reduction components,” the paper said. The plan assumes that large bank servicers, which service approximately 60% to 70% of all outstanding residential mortgage loans, would look with favor on a plan allowing the sale of blocks of distressed loans out of MBS trusts. They’d get rid of their servicing responsibilities on those notes. After the sale, smaller, default management-oriented special servicers would be engaged by the new owners to handle these borrowers and assets, according to the white paper. There are roughly 4 million residential mortgages in some stage of default or already foreclosed on. Dorchuck and his co-authors cite a report from Amherst Securities in early October that states another 5 million to 7 million borrowers may enter the foreclosure process before the end of 2012. Meanwhile, servicers have modified about 634,000 loans for borrowers via HAMP and another 1.5 million received non-HAMP modifications through February. “Without changes, the volume of foreclosures will continue to outpace the number of loan modifications,” Dorchuck, Lockhart and Mills wrote in the white paper. Write to Jason Philyaw.