A dispute within the banking industry is making it more difficult for homeowners with second mortgages to refinance and avoid foreclosure.

Yes, that flies in the face of everything lenders have said about wanting to make it easier for borrowers struggling with unaffordable mortgages to save their homes.

But here's how commercial banks and Fannie Mae -- one of the two, big, government-chartered companies that finance mortgages -- are making a bad situation worse.

During the housing boom, many buyers financed part of their purchase with a home equity loan instead of a down payment -- a so-called piggyback loan. Others borrowed against the soaring value of their homes during the early 2000s.

As a result, those homeowners need the consent of the lenders holding their second mortgages before they can refinance their primary mortgage.

In legal terms, the bank holding the home equity loan must agree to subordinate its loan to the primary mortgage, which means the primary lender would get paid first if the borrower defaults.

Until recently, it was routine for home equity loan holders to agree.

But in February, National City Bank, a major home equity lender, decided to reject such requests.

When home equity customers asked to refinance their primary loans, the Cleveland-based lender said they'd need to repay their second mortgages as part of the deal.

Needless to say, most homeowners don't have that kind of money sitting around. They had to do a cash-out refinancing, which means they had to borrow enough to pay off their primary and secondary mortgages.

By forcing homeowners to combine all of their debt into a single loan, National City was trying to escape many of the questionable home equity loans it had made and push all of that risk onto the entity that owned the refinanced mortgages.

And make no mistake about it: National City has a lot of risky home equity loans on its books. It pushed piggyback loans in what became some of the most distressed markets in the country -- those with the highest foreclosure rates coupled with rapidly falling home prices.

National City's move did not sit well with Fannie Mae, which buys mortgages from banks, bundles thousands of them together and sells that debt to investors. As you might expect, that's increasingly difficult to do.

With other banks beginning to follow National City's lead, Fannie Mae struck back in late March.

It said it would no longer buy refinanced mortgages from distressed markets if any of the money was used to pay off a home equity loan. In other words, it now forbids cash-out refinancing to satisfy the likes of National City.

With Fannie Mae and Freddie Mac, the other big government-chartered mortgage lender, buying more mortgages than ever, it's virtually impossible to find a lender that isn't bound by this edict. (Freddie Mac tends to follow Fannie Mae's lead on these sorts of rules.)

Fannie Mae will make an exception for borrowers who have 25% or more equity in their homes. But that's virtually meaningless. Almost no one struggling with an unaffordable mortgage has that kind of equity.

Homeowners in distressed markets also are the ones who need the most help getting out of runaway adjustable-rate loans they can't hope to repay.

About 9,600 ZIP codes in 34 states have popped up on some bank or insurance company lists of distressed areas. Virtually every ZIP code in California, Florida, Michigan, Arizona, Nevada and Ohio shows up on someone's distressed list. The result of this banking-industry battle is all too predictable.

"More people who can't refinance will walk away from their homes, meaning more homes will go into foreclosure," says Ed Craine, CEO of mortgage broker Smith-Craine Finance in San Francisco.

"It's hard to see how letting a home go into foreclosure benefits anyone, especially the bank, because those homes generally sell for 20% to 30% less than they would if they were occupied," Craine said.

Yet we also see home equity lenders blocking short sales.

Homeowners who owe more than their homes are worth can't refinance. But they can ask lenders to let them sell the property for the best possible price and write off the difference.

In that situation, the bank holding the second mortgage doesn't get paid until the primary lender gets all of its money. In many cases, there's not much left for the home equity lender, who then rejects the sale.

Many of those homes wind up in foreclosure.

Fannie Mae has extended the time that delinquent borrowers have to get modifications on their loans from four months to six months, which could help more borrowers stay in their homes.

With banks working with so many borrowers to try to work out an alternative to foreclosure, Craine says the extra two months could make a difference in keeping some borrowers in their homes.

But other new rules won't help consumers.

Fannie Mae announced that it won't approve loans to buyers with credit scores of 580 or less. In practice, it's been virtually impossible to make loans to borrowers with credit scores under 620, Craine says, so this edict shouldn't have that much effect on the market.

But Fannie Mae also is making it harder for consumers with foreclosures on their credit history to qualify for mortgages.

Consumers had been allowed to borrow again after four years, but the period now has been extended to five years, though Fannie Mae says it may be willing to be flexible for borrowers with documented extenuating circumstances surrounding their foreclosures.

By Amy Buttell Crane

Interest.com Contributing Editor

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