In a conference call on Feb. 14, Secretary Shaun Donovan of the Department of Housing and Urban Development promised about 90 mortgage-backed bondholders that the $25 billion national mortgage settlement would include a 15 percent cap on the number of investor-owned loans that the five settling banks would be permitted to modify, according to the three participants in the call.

Donovan made the promise in response to MBS investor concerns that banks would shift the cost of the settlement onto their shoulders by writing down the principal in securitized mortgages, rather than in the loans banks hold in their own portfolios. He had already said in a press conference that the settlement would provide incentives for the settling banks -- Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, and Ally Financial -- to reduce the principal in their own portfolio loans, estimating that "a relatively small share, in the range of 15 percent" of the write-downs would be in investor-owned mortgages. In the Feb. 14 call with bondholders, according to the three participants, Donovan went a step farther, assuring MBS investors that the written settlement agreement would limit the percentage of investor-owned loans the banks were permitted to modify.

But on Monday, when the settlement documents were finally released, more than a month after the deal was first announced, there was no such cap. That's left a contingent of major mortgage-backed bondholders feeling betrayed -- and expecting the worst from the banks in the settlement. "If we've missed (documentation of the 15 percent cap), please Secretary Donovan, let us know where it is," said Vincent Fiorillo, a portfolio manager at DoubleLine Capital and president of the board of the Association of Mortgage Investors.

A spokesperson for Donovan, Derrick Plummer of HUD, said the MBS investors are not recalling the secretary's comments correctly. "I was on the call with the secretary and the AMI group," he said. "The secretary did not make the suggestion there would be a cap."

From a purely legal standpoint, there's a good argument to be made that mortgage-backed noteholders are no worse off now than they were before the national settlement. The deal preserves their rights to bring their own breach-of-contract and securities claims against the banks. And as I predicted, the settlement acknowledges the primacy of the pooling and servicing agreements that govern MBS trusts. The exhibit detailing the terms of loan modifications the banks can undertake to satisfy their $17 billion write-down commitment contains a provision stating that banks operating as servicers in MBS trusts must comply with those contracts. (The actual provision is a thicket of impenetrable legalese, but that's what it boils down to.)

If the agreement governing a trust, in other words, prohibits mortgage loan modifications without investor consent, banks are still bound by that prohibition. If, on the other hand, investors granted servicer banks more discretion in those MBS contracts, then banks can take advantage of that discretion. One of the goals of settlement drafters, I've been told, was to prompt more discussion and consideration of loan modification between banks and investors, in the hope that principal write-downs (perhaps accompanied by some compensation to bondholders) could benefit both banks and investors, in addition to homeowners.

The settlement offers banks an incentive to write down loans in their own portfolios by offering them more credit toward their total commitment when they modify mortgages they own. Banks receive a $1 credit for every dollar of principal they reduce in a loan they own outright. They earn a 45 cent credit for every dollar written down on a securitized loan. That incentive, in combination with the strictures of the pooling and servicing agreements with investors, was intended to limit the number of securitized mortgages the banks would modify.

But there are powerful reasons why banks might prefer to write down principal in investor-owned mortgages instead. For one thing, they don't have to record that loss on their books (although most of the settling banks have already accounted for write-downs.) For another, banks often have an underlying incentive to reduce homeowners' primary mortgages. Most securitized mortgages, remember, are first-lien loans. The vast majority of second-lien loans, by contrast, are bank-owned. When banks reduce the principal in a first-lien mortgage, they improve their own prospects as a second-lien holder. (A HUD spokesperson said there is no way to resolve the conflict between first and second lien holders without foreclosure, which isn't in the interests of the investor, the homeowner, or the housing market.)

The Association of Mortgage Investors highlighted the conflict between first and second lien owners in a statement issued immediately after the settlement documents were released. "The settlement is expected to also draw billions of dollars from those not a party to the settlement (because) it places first and second lien priority in conflict with its original construct," the AMI press release said. "It is unfair to settle claims against the robosigners with other people's funds."

There's one additional incentive for banks to modify mortgages they service, rather than those they own, according to a major MBS investor I spoke with Tuesday. If the principal reduction takes place under the Home Affordable Modification Program (HAMP), he said, the servicer can receive fees for the modification. "This may actually create capital for the banks," he said. (HUD's spokesperson said the investor misunderstands the interplay between HAMP and the national settlement.)

On a more serious note, the MBS noteholder pointed out that banks should already have been engaged in those loan modifications that would benefit investors (for instance, reducing the principal in a loan that would otherwise lead to a foreclosure in a neighborhood where houses aren't selling). The additional write-downs required by the national settlement may lead to principal reduction that's not in the interest of investors. (HUD counters that under the settlement terms, servicers must evaluate modification of investor-owned loans under the Treasury Department's HAMP standard; banks may only engage in loan modifications that are a benefit, under this standard, to investors.)

The perceived incentives for banks to modify securitized loans, and at their expense, are the primary reasons why MBS investors were so agitated when the broad terms of the settlement were announced last month, and why they demanded the conference call with Donovan. But instead of the cap on investor-owned mortgage modification they thought they'd been promised, the settlement agreement actually mandates that 30 percent of the principal reductions be on first-lien loans.

AMI is calling for the settlement to be amended to increase the transparency of the loan modification process and to cap the dollar amount of the deal that will be borne by investors (who, as the AMI statement points out, include public pension funds). The group hasn't specified what action it will take if the agreement isn't changed, but investors could conceivably file objections in federal court in Washington.

(This blog post has been updated to include responses from a HUD spokesman.)

(Reporting by Alison Frankel)