Many homeowners who want to refinance to avoid foreclosure are hoping to get help from the Federal Housing Administration (FHA). One plan under consideration would offer $300 billion in new FHA loans for that purpose, but there's passionate resistance from critics of the bill.

The FHA insures loans against losses if the borrower defaults. By doing so, the government agency assumes substantial risk on behalf of investors who supply the cash to support mortgages. As a result, lenders are more lenient with homeowners. The risk of loss is ultimately transferred from the lender or mortgage investor to the American taxpayer. In exchange for that acceptance of extra responsibility, the average consumer benefits from easier and cheaper mortgages. Generally, the trade-off is a good one for taxpayers, because government-backed mortgages have helped people afford new homes since the Great Depression.

New refinancing initiatives

Now, under a new initiative crafted by the Democratic Chairman of the House Financial Services Committee, the FHA would begin to ease its standards, and make it even easier to refinance. It would offer refinancing to about a million homeowners who currently owe more mortgage debt than the value of their property. Some additional funds to pay for the plan would be raised by charging homeowners a 3 percent fee on refinanced loans, plus small annual FHA insurance premiums. But this may not be enough to convince officials in Washington to let the FHA loosen its wallet and lend to people who have fallen behind on their payments, have poor credit, and carry a large ratio of debt to income.

Potential win-win for all

One of the most important and fundamental concepts behind the proposal is that lenders stand to lose more through foreclosure than they do by accepting only a partial repayment of debt. Champions of the plan argue that it will save lenders money by curtailing the losses that they'd inevitably face anyway, as costly foreclosures continue. At the same time, scores of desperate Americans would benefit greatly by avoiding foreclosure, and being able to keep their homes. Supporters of the proposal consider it a total win-win for lenders, borrowers, and the housing market.

Will lenders forgive and forget?

For the plan to work, however, lenders would have to agree to forgive large amounts of debt that has already been sold to third party investors. There's little incentive for mortgage investors who provide the cash to those lenders to voluntarily agree to such a plan. They have a huge financial stake in the outcome. Even if homeowners default, investors can still sue banks and mortgage companies for the money they're owed under pre-existing contractual agreements. Investors have already resisted similar efforts, and show no signs of relenting at this stage of the game.

The proposal as it now reads has inherent weaknesses and lacks unified support. Delays and revisions are likely to postpone any FHA-backed refinance rescue efforts, at least until after the presidential election.

Also see our Government-Backed Loans resource for more information.

Published on May 11, 2008