Maurna Desmond, 03.20.09, 07:50 PM EDT
Claims of fraud in the subprime mortgage market illuminate a murky world.

When Texas billionaire Wilbur Ross sued a Connecticut hedge fund Thursday, he shined a light into one of the murkier regions of the subprime mortgage morass: loan servicing.

Ross' American Home Mortgage Servicing claims Carrington Capital asked it to block the sale of homes to siphon money away from other investors and enrich itself. Irving, Texas-based American Home services some of the loans related to mortgage-backed securities where Carrington is the junior investor. "Carrington resorted to fraud when the subprime market deteriorated," says Brian O'Tero, a lawyer at Hunton & Williams representing American Home. Carrington declined to comment.

The suit, first reported on Housingwire.com, underscores the complicated relationship that exists between servicers and mortgage investors, especially when the one collecting payments also has skin in the game. (See "Tranche Warfare.")

Loan servicers act as middlemen between the borrowers paying the loan and investors who own the mortgages. They are responsible for monitoring delinquencies and managing billions in monthly payments. Though they play a growing--and crucial--role in unwinding the subprime mortgage mess, they have virtually no oversight. American Home mortgage is the largest servicer of subprime and so-called "Alt-A" mortgages. Some of the biggest banks on Wall Street dominate the business. Citigroup (nyse: C - news - people ), Wells Fargo (nyse: WFC - news - people ), JP Morgan Chase (nyse: JPM - news - people ) and Bank of America (nyse: BAC - news - people ) service 55% of outstanding mortgage debt.

The four loan pools identified in the lawsuit were created from the remains of subprime lender New Century, which Carrington bought in 2007. American Home alleges the hedge fund tried to keep getting paid interest on the mortgages it held by insisting the homes be sold at above-market values, stalling the sales. At sale, the proceeds would have gone to investors senior to Carrington. American Home says the hedge fund has also been pulling more loans into its own servicing shop, called Carrington Mortgage, in order to keep its activities under wraps.

It's a twist on what critics complain is a major problem in the industry: Servicers are often investors on the mortgages they manage. "When someone is servicer and junior investor, they have a serious conflict of interest," says Jeff Gundlach chief investment officer of TCW, an L.A.-based money manager. "Their interest is supposed to be to that of the investor, but it can't be."

Delaying foreclosure or masking rising defaults can keep the money flowing to the junior investors. This hurts senior investors, often pension funds and life insurance companies, who paid a premium to buy up "Triple A" bonds which were supposed to be as safe as Treasuries.
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Says Joseph Mason, a professor of finance at Louisiana State University and fellow at Wharton Business School: "Investors are right to be skeptical of the servicing industry's capacity to walk the tightrope of modifying loans in both investors' and borrowers' joint interests."

Concern about servicer integrity is heightened by the key role that the Obama administration is hoping they'll play in the costly unwind of the subprime mortgage mess. The plan is for servicers to modify delinquent loans to more affordable levels, incentivized by taxpayer funds. (See "Loan Modification Plan Gets Sweeter.") Despite that fact that the servicers collect payments, monitor delinquencies and manage billions in cash flow, they have virtually no regulatory oversight. They only report as much detail as they choose to. Industry groups such as the American Securitization Forum have repeatedly called for increased transparency and regulation.

American Home isn't the only one crying manipulation. Carrington filed its own complaint in February against a loan servicer alleging it was selling properties at "fire sale" prices because it was short on cash. The defendant: American Home.

Forbes