Bank of America Corp's $8.5 billion settlement to clear up its mortgage bond mess isn't a done deal and could be challenged -- if the large number of investors locked out of negotiations decide to organize.

The deal was struck with trustees for $424 billion of mortgage bonds and has the backing of 22 institutional investors including Pacific Investment Management Co (PIMCO), the world's largest bond fund manager, and BlackRock Inc .

I think people are surprised the number is as low as it is, Gregory Taxin of Spotlight Advisors LLC, which advises pension funds on mortgage bond investments, said of the settlement. You've seen a lot of research estimates that the number was going to be five or more times this number.

The settlement needs court approval, and investors who were on the sidelines are being urged by an advocate to put up a fight.

If investors were to open their mouths they can push for a better and fairer settlement, or they can get 2 cents on the dollar like they are getting, said Bill Frey of Greenwich Financial, a firm that structures asset-backed securities.

He has been organizing pension funds and hedge funds that hold mortgage bonds to demand Wall Street banks buy back soured home loans that were packaged into bonds. He said investors angry about the settlement had bombarded him with emails.

The 530 trusts in the settlement are governed by New York law, and the deal requires it be approved by the state's supreme court. The case was assigned to Judge Barbara Kapnick on Wednesday.

The trusts bought home loans from mortgage lender Countrywide Financial, now part of Bank of America, and issued bonds to investors with warranties about the quality of the underlying loans. Money that flowed to the trusts from homeowners paying down their mortgages was then distributed to investors holding the bonds.

The main trustee, Bank of New York Mellon Corp , will have to show the judge it knows the percentage of loans that breached warranties, and from that can value the settlement, said Isaac Gradman, an attorney who has brought legal action over mortgage bonds. He is not involved in the Bank of America case.

SETTLE OR LITIGATE?

The attorney who represented the 22 investors in the settlement noted that five experts evaluated the pact.

I have a hard time seeing how anyone could recover more than this in six or seven years of litigation, Kathy Patrick, a partner at law firm Gibbs & Bruns, told Reuters' legal blog On The Case.

I don't know of any long-term holder of these certificates who wouldn't think this is a good deal, she said.

Gradman questioned whether institutional investors supporting the deal hold at least 25 percent of most of the mortgage bonds, a level that allows them to direct the trustee of a bond issue to strike a settlement.

Does the investor group that negotiated this settlement actually have standing in all 530 trusts? My sense is they don't, said Gradman.

In a May securities filing, Bank of America said the 22 investors held at least 25 percent of 230 trusts. Wednesday's settlement agreement does not specify the investors' holdings in the 530 trusts.

Large groups of investors also have organized to fight for compensation from other banks over mortgage bonds, which were often sold to pension funds as low-risk securities but plummeted in value during the housing crash.

Texas lawyer Talcott Franklin has developed a clearinghouse of investors that he has said holds at least 25 percent of 3,763 out of 6,882 mortgage securitizations he has identified.

New York attorney David Grais has also led the charge against Wall Street over soured mortgage bonds. Both Franklin and Grais declined to comment.

Gradman said he expects a challenge to the Bank of America deal but investors will need to organize quickly.

Investors, he said, could make a case for rejecting the deal by exposing poor loan underwriting on bonds, and emphasizing the investors backing the settlement hold small positions in some bonds.

I don't think you can have this small group release all these other claims. I think that would be compelling for a judge, he said.

The judge could order Bank of America to contribute more to the deal or reopen talks with a bigger pool of investors, he said.

(Reporting by Tom Hals; Editing by Martha Graybow, Gerald E. McCormick and Phil Berlowitz)

Settlement