Conflicts of mortgage investors and servicing companies gumming up the nation’s housing recovery could be avoided in the future by rules defining the safest mortgages, a top regulator said on Wednesday.

Predetermined practices could help avoid conflicts, which include servicing mortgages to the benefit of one type of investor over another, or where the servicer may be protecting its own interests over investors, Federal Deposit Chairman Sheila Bair said in Senate Banking Committee testimony.

Regulators have a window to fix these conflicts as they define "qualifying residential mortgages," the designation that would help lenders avoid the risk-retention rules that cut into their profits. The coveted designation is meant to help set a standard for securities that avoids pitfalls of the past, and promote greater liquidity for the nation’s mortgages.

"This rulemaking process also provides a unique opportunity to better align the incentives of servicers with those of mortgage pool investors," she said in the prepared remarks.

Under new QRM rules, servicers — which collect payments and work with troubled borrowers facing foreclosure — should disclose any ownership interest in other loans secured by the same property, Bair said.

Bair referred to second-lien mortgages, which have long been obstacles to resolving defaulted loans. Owners of the second-liens — primarily the nation’s four biggest banks — have been reluctant to take write-downs on their junior holdings when modifying terms of the first-lien, creating friction with owners of the main mortgage.

"Serious conflicts such as this must be addressed if we are to achieve meaningful long-term reform of the securitization process," she said.

Addressing the current crisis, she said regulators must "tackle the second lien issue head on," perhaps by requiring the servicers to take meaningful write-downs on those loans when a first-lien is modified or approved for a short sale.

She also said leveraging QRM rule-making could help avoid "tranche warfare," where one investor might want a loan to be modified for its economic benefit, while another might claim a foreclosure is best.

The QRM rules could provide incentives for servicers to mitigate losses on mortgages with methods that benefit all investors, rather than one class, she said. They could also establish a pre-defined process to address subordinate liens. (Reuters)