Investment funds are battling with large banks over the fine print of a U.S. housing rescue plan that will determine many of the final winners and losers in the recent housing bust.

At issue are bad bets on high-risk mortgages and the second-lien home equity loans that allowed many borrowers to buy a home they could not afford.

While investors gobbled up most mortgages and related securities created during the recent housing boom, big lenders like Bank of America , Citigroup and JPMorgan Chase are now servicing those loans and collecting the monthly payments for investors.

Officials want to see banks give troubled borrowers a break on those payments -- a move that could come at investors' expense.

Large insurers like Prudential Financial Inc

and MetLife Inc are joining asset managers like Fortress Investment Group and BlackRock Inc to warn lawmakers that big banks could game the housing rescue at their expense, said sources familiar with the strategy.

A plan that would give mortgage servicers broad power to retool problem loans has raised the investment community's hackles. That safe harbor legislation, which would shield servicers from investor lawsuits over reduced income, has passed the House of Representatives but investors are sending lobbyists to slow it down in the Senate.

Some of those investors have joined together and hired Patton Boggs LLP, one of Washington's largest lobbying specialists, to argue that large banks have a conflict of interest as mortgage servicers and holders of second liens.

There is no prohibition against a servicer acting in his self-interest in modifying these loans, said Micah Green, an attorney for the lobbying firm and a former co-chief executive of the Securities Industry and Financial Markets Association.

Bank of America, the nation's largest mortgage servicer, held $148 billion in second liens at the end of last year, according to Inside Mortgage Finance. Wells Fargo & Co. , the second-largest servicer, held $129.9 billion in second liens.

While billions of dollars are at stake, many banks and investors bet on so many parts of the housing market that their self-interests are not always easily defined. Investment arms of big banks bought up securities backed by first mortgages while their mortgage arms wrote home equity loans as both turned sour. Large banks remain invested in both first and second liens.

We have a broad and diverse group of member-firms which, together, are involved in every aspect of the financial markets, and we are working with all of them to find workable solutions to the current financial crisis, SIFMA, the Wall Street lobbying group, said in a joint statement with the American Securitization Forum.

Both associations represent large banks, investment funds and other mortgage stakeholders.

With veto power over refinancings, banks holding second liens have been a key stumbling block for various federal housing rescue programs because plummeting home values have provided them little prospect for near-term repayment.

This week, lobbyists for mortgage investors were on Capitol Hill explaining their position to staff on the Senate Banking Committee, which will draft the safe harbor rules.

They're warning that the safe harbor and Obama modification plan will lead to servicers running amok doing modifications, said one Senate staffer familiar with this week's meetings.

DOUBLE DOWN?

Investors fret that the Obama administration will use the incentives as another way to dole out aid to big banks in which Washington already has invested hundreds of billions of dollars.

On Wednesday, the Treasury said that it has set aside nearly $10 billion in incentive money for six large mortgage servicers to encourage them to modify troubled loans. The mortgage specialty arms of Citi, JPMorgan and Wells Fargo could each receive more than $2 billion in payouts from a $50 billion kitty.

The Hill is just not very well-briefed on this. Once lawmakers learn more, it will be very interesting to watch how they settle the conflict of interest, said one advocate for investment funds that hold large mortgage investments.

(Editing by Andrea Ricci)

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