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* Lenders need control of note before foreclosing
* Decision does not apply retroactively
* Fannie Mae, Freddie Mac regulator urged no retroactivity
By Jonathan Stempel
June 22 (Reuters) - The highest court in Massachusetts ruled that lenders must have proper paperwork to conduct foreclosures but said its decision applies only to future property seizures, averting a potential flood of problems for banks trying to take possession of homes.
Friday's unanimous decision by the Massachusetts Supreme Judicial Court, in a case that had drawn national attention, avoids the prospect that title could be clouded on thousands of recently foreclosed properties in the state.
That was a victory for the Federal Housing Finance Agency, which oversees mortgage financiers Fannie Mae and Freddie Mac. It had argued that a ruling that applied retroactively threatened the orderly operation of the mortgage market, and could have imposed "dramatic" costs on taxpayers.
Still, the decision will require lenders in the future to have or act on behalf of someone who has a borrower's underlying note in order to foreclose.
While it applies only in Massachusetts, the decision is a precedent that homeowners in other states may now use.
The case had been brought by Henrietta Eaton, who sought to void a 2010 foreclosure proceeding by arguing that Green Tree Servicing LLC, which collected payments on a $145,000 loan for her Boston home, did not have the underlying promissory note.
"It is a victory for homeowners going forward, and can help them in reaching settlements or loan modifications to avoid foreclosure," said Sam Levine, a recent Harvard Law School graduate who argued Eaton's appeal.
"But we are disappointed that people who already lost their homes to foreclosure will not have any recourse."
An FHFA spokeswoman said the regulator is pleased that the rule will not apply retroactively, which "would have wreaked havoc with the operation of title recording after foreclosures."
Falling housing prices and elevated foreclosure rates remain drags on the U.S. economy despite February's $25 billion settlement among five big mortgage lenders and state and federal officials to address alleged mortgage abuses.
Foreclosure starts, defined as default notices or scheduled auctions, were filed on 109,051 U.S. properties in May, up 12 percent from April, according to RealtyTrac Inc. An average of 1.6 million starts were brought annually in the last five years.
In Friday's decision, Judge Margot Botsford wrote that applying the new rule retroactively could cause "significant difficulties" in deciding who has good title to property.
She also said she had no reason to doubt that lenders had been exercising good faith in earlier foreclosures, and relying on existing law.
"There may be particular reason to give a decision prospective effect where -- as the argument is made here -- prior law is of questionable prognosticative value," she wrote.
The Massachusetts court did grant relief to Eaton, saying the new rule should apply to her because she had brought the case, and that she may renew her efforts to keep her home.
Levine said Massachusetts homeowners could also be aided if state legislators were able to pass a bill requiring mandatory mediation of lender-homeowner disputes.
The case is Eaton v. Federal National Mortgage Ass'n et al, Massachusetts Supreme Judicial Court, No. SJC-11041.