Foreclosures: Feds to the Rescue?

Banks may be required to offer interest rate relief for strapped homeowners. But it's unclear who will qualify and if the plan would put a dent in foreclosures

The Federal Deposit Insurance Corp. and the Treasury Dept. are working on a major program to prevent widespread foreclosures that would include government guarantees of home mortgages.

The plan would use $50 billion from the recently passed bailout package to provide as much as $500 billion to $600 billion in government guarantees on up to 3 million at-risk mortgages. It might require banks and savings and loans to offer loans with lower interest rates for a five-year period, while shifting to the government any risk if the home doesn't recover its full mortgage value within that time.

Without giving details, FDIC Chairman Sheila Bair discussed the program on Oct. 29 at an international deposit insurers' conference in Arlington, Va. She said the agency has developed "a federal program to help more borrowers avoid foreclosure.…Such a framework is needed to modify loans on a scale large enough to have a major impact."

Bair said discussions are ongoing with the Treasury Dept., according to wire reports. The proposal could be out as soon as Oct. 30, says a lobbyist familiar with both elements of the plan and negotiations. However, a Treasury Dept. spokeswoman denied that a proposal is ready. "That is simply inaccurate," said Treasury spokeswoman Jennifer Zuccarelli. "We are looking at a number of proposals on foreclosure prevention, but no one proposal has been decided upon." Details of the plan the FDIC is pushing could change as Treasury—which has authority to administer most facets of the banking bailout—evaluates it. The lobbyist said there may yet prove to be friction with the White House over the plan, as well.

Not Enough?

A mandatory mortgage-relief program would be the government's boldest move on behalf of homeowners since the subprime crisis began picking up steam last year. Bair made a similar proposal six months ago, but it was dismissed without much discussion. Until now, a Bush Administration plan that was voluntary for banks has failed to spur enough loan modifications and prevent foreclosures.

Still, critics say that the five-year loan modification program could be putting off the inevitable for borrowers, and that the $50 billion committed to backing it up may not be enough to put a serious dent in the wave of foreclosures.

According to the lobbyist, the program would require banks, savings and loans, investment funds, hedge funds, and other holders of mortgages to restructure the loans based on a homeowner's ability to pay lower monthly mortgage payments. The government would guarantee a second loan on the home, so banks and other lenders would not lose any money in a mortgage modification. The homeowner would get lower payments for the five years. And if the homeowner defaulted and went into foreclosure anyway, the government would have to make good to whoever had issued the loan.

"Winners and Losers"

Exactly how that would work isn't clear. The government could guarantee a loan that pays off part of the principal, thus lowering the payment. Or it could guarantee a loan that replaces the original mortgage—a prospect that could raise thorny legal issues (BusinessWeek, 10/15/08) because of the way mortgages have been sliced and diced into securities.

Other key details also have not been disclosed. It's not known to what levels borrowers will be able to reduce their mortgages. It's also unclear who would be eligible for the loans. Eligibility could be based on such factors as how big the mortgage is relative to the homeowner's income or how up-to-date their mortgage payments are. "Drawing that line will create winners and losers and create political issues," says the lobbyist.

The lobbyist said the program would only cover five years, because a permanent reduction would require too much of a sacrifice from the lenders. "That's too much of a loss for the industry," he said.

Doubts About Plan's Effectiveness

Some analysts say such a program based on government guarantees ultimately won't work. For one thing, it would fail to fix the underlying problem: borrowers' inability to pay. Many homeowners are in trouble because they've lost their jobs or will be losing them as the recession picks up steam. For them, paying off a mortgage even at lower rates may be impossible.

The proposal's success could hinge on unrealistic expectations of an economic recovery, wage increases, and a recovery in home prices. After five years, homeowners may need to refinance or sell their homes at a higher price.

"Buying a lot of mortgage insurance—isn't that how we got into this mess?" says Peter Morici, a professor at the University of Maryland's Robert H. Smith School of Business. "Something must be done [to stem foreclosures], but the government will have to appropriate real money." Morici says the government would have to spend hundreds of billions of dollars to prevent large-scale foreclosures.

But others expressed relief that a mandatory program may be forthcoming at the federal level.

"We are heartened that it seems more elected officials and regulators realize that more has to be done for homeowners," says Kathleen Day, a spokesperson for the Center for Responsible Lending, an advocacy group for borrowers. "To actually get to the root cause of financial turmoil you have to keep more people in their homes."

Keith Gumbinger, vice-president of the mortgage consulting firm HSH Associates in Pompton Plains, N.J., says he's encouraged by the FDIC's announcement. "It sounds like the FDIC has learned a few things about servicing and financing with its experience with IndyMac," says Gumbinger, referring to IndyMac Federal Bank (IDMCQ.PK), which was seized by the feds in July and has been undergoing a fast-track loan modification program (BusinessWeek, 10/8/08).

But a mortgage plan can only be assessed once it's revealed in its entirety, Gumbinger says. "The devil's in the details."