Nov. 14, 2008

Officials at the Federal Deposit Insurance Corp. yesterday detailed a plan to prevent 1.5 million foreclosures in the next year by offering financial incentives to companies that agree to sharply reduce monthly payments on mortgage loans.

The proposal, which has the support of leading congressional Democrats, would considerably expand the scope and force of the government's efforts to stem foreclosures. Agency officials estimated the cost to the government at $24.4 billion.

FDIC Chairman Sheila C. Bair continues to face opposition within the Bush administration. Treasury Secretary Henry M. Paulson Jr. said Wednesday that he opposed funding the plan from the government's $700 billion financial rescue fund, which has been used primarily to rescue banks and encourage lending. FDIC officials say they are still in talks with the Treasury, but proponents increasingly view the Bush administration as a roadblock with an expiration date.

"We think it's essential that we actually strike at the underlying cause of the problems in the financial markets," said Michael Krimminger, special adviser for policy at the FDIC. "We think it's time to make a decisive difference in the housing markets on foreclosures."

The FDIC proposal, which is scheduled to be announced today, goes farther toward helping borrowers than existing modification efforts. At the same time, the initiative is designed to be less expensive for mortgage companies because the government would pick up part of the tab.

Borrowers who have missed at least two monthly payments would be eligible for a reduction in their payment. The new payment would require that they spend no more than 31 percent of their monthly income, a relatively conservative standard. By comparison, lenders historically calculated that borrowers could afford to spend up to 28 percent of monthly income before taxes on housing.

In exchange, mortgage companies would receive a basic guarantee: If the borrower falls behind on the new monthly payments and the company ends up losing money on the loan, the federal government will cover half the loss in most cases.

The estimated cost of the plan is based on the assumption that only one in three borrowers who get a modification will be unable to make the lower payments. That would require a higher success rate than existing modification programs have achieved. About 45 percent of borrowers who received loan modifications from mortgage companies last fall already have slipped back into default, according to a Credit Suisse research note.

But FDIC officials say the comparison is misleading because the FDIC plan would give borrowers a much better chance at success.

"Most of the modifications that have been done to date are not sustainable modifications," said Richard Brown, the FDIC's chief economist. He called them "repayment plans," meaning that borrowers are getting a second chance but not a payment reduced to a level they can afford.

Members of the Senate Banking Committee yesterday expressed support for the Bair plan and anger at Paulson's opposition.

Sen. Christopher J. Dodd (D-Conn.) also said that he planned to introduce legislation that would allow bankruptcy courts to modify mortgage loans, another step long sought by consumer advocates and strongly opposed by the banking industry.

"It is confounding to me why the Secretary of the Treasury and others refuse to understand that this is the heart of the problem," Dodd said. "Until we solve the foreclosure problem, we will not have any hope of solving the larger problem."

Many economists believe the economy will continue to suffer as long as the pace of foreclosures keeps home prices from stabilizing.

The mortgage industry is concerned that any new modification plan would persuade some people to stop making mortgage payments in addition to helping people who already have stopped making payments. The industry argues that this would translate into higher interest rates because investors would demand compensation for the increased risk of loan defaults. That, in turn, would limit the number of people who can afford mortgage loans.

The industry has particularly opposed the idea of allowing bankruptcy courts to modify mortgage loans. The courts have the power to modify other kinds of debt to levels that are affordable for the borrower, including mortgage loans on second homes, but the industry won an exception years ago for mortgage loans on primary homes. Consumer advocates want Congress to change the law, viewing the court system as an efficient way of modifying loans at no cost to taxpayers. The industry continues to caution that the consequences would be considerable.

"The longer-term issues may be greater than the short-term gain," Bank of America executive Anne Finucane said in testimony before the Senate Banking Committee yesterday.

That line of reasoning held sway in Congress for years. But Dodd said he has seen a change in the Senate.

"I think we're getting to the tipping point with some of my colleagues that they will accept the gravity of this situation," he said.

President-elect Barack Obama expressed support for allowing bankruptcy courts modifications during the campaign. He has not commented on a plan of the kind proposed by the FDIC.

In the early stages of the foreclosure crisis, mortgage companies insisted that loans could be reworked only on a case-by-case basis. That sharply limited the pace of modifications. FDIC officials estimate that even now, companies are modifying only 4 percent of seriously delinquent loans each month.

Bair has argued for more than a year that loans should be reworked according to a standardized formula to hasten the pace. This summer, she established her own demonstration project after the FDIC, which is primarily responsible for insuring bank deposits, seized control of IndyMac Bancorp, a California mortgage lender.

That effort has influenced several other home loan modification programs, including an announcement Tuesday by mortgage giants Fannie Mae and Freddie Mac. But that program is limited in scope. It applies only to the relatively conservative loans owned by those companies, includes only borrowers who have missed at least three monthly payments and reduces payments to equal 38 percent of monthly income.

The FDIC program would focus on the alternative and subprime loans that sprang up during the housing boom and would offer borrowers much deeper cuts in monthly payments. The FDIC estimates that 1.4 million borrowers with such loans are at least two months late on their payments, and another 3 million borrowers will miss at least two payments by the end of next year. The agency estimates that half those borrowers, or about 2.2 million people, would receive a loan modification under the program, and that about 1.5 million will successfully avoid foreclosure.

Under the terms of the proposed FDIC program, lenders would reduce monthly payments primarily by cutting the borrower's interest rate to a minimum rate of 3 percent. If necessary, the company could also extend the repayment period on the loan beyond 30 years, reducing each monthly payment. Finally, in some cases, companies could defer repayment of some principal. The borrower still would be on the hook for the full value of the loan.

Officials said their experience at IndyMac showed that principal reductions were not necessary. So far, the FDIC has modified about 20,000 IndyMac loans. In 70 percent of the cases, the FDIC was able to create an affordable payment solely by reducing the interest rate. In 21 percent of the cases, the agency also extended the life of the loan. In 9 percent of the cases, it delayed repayment of some principal.

The plan includes a careful mix of carrots to encourage industry participation and sticks to encourage maximum modifications. Mortgage companies would be paid $1,000 to modify each loan, but participating companies must agree to modify as many loans as possible.

The loss sharing guarantee begins only after the borrower has made six payments on the modified loan. And the government would not cover losses on loans where the modification did not lower the monthly payment by at least 10 percent.

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