The Bush administration sent a shot across the bow of the mortgage lending industry last week: Either try to work things out quickly with Federal Housing Administration (FHA) mortgage borrowers who've missed monthly payments, or risk heavy financial penalties when they go to foreclosure.

The warning to lenders came in the form of a proposed regulation issued April 14. If finally adopted by HUD, it would be the lending industry's toughest set of rules mandating forbearance or loan-modification "workouts" with defaulting homeowners whenever possible to avoid foreclosure.

The policy would also guarantee FHA-insured homeowners the maximum opportunity to arrange some form of accommodation or repayment plan with their lender prior to foreclosure and loss of their home.

Conventional mortgage market giants Fannie Mae and Freddie Mac also have aggressive "loss-mitigation" programs directing lenders to seek workout arrangements whenever feasible as alternatives to foreclosure. However, neither corporation imposes financial penalties as severe as those proposed by HUD.

"We are working to ensure that any qualifying FHA borrower is afforded the opportunity to explore all options to keep their home," said HUD Secretary Alphonso Jackson. "Our lenders must engage in loss-mitigation efforts to help people stay in their homes, help stabilize neighborhoods and prevent loss to FHA's insurance fund." The insurance fund compensates private lenders whenever an FHA loan goes to foreclosure. The cost per insurance claim is often in the tens of thousands of dollars, whereas a successful repayment plan or loan modification accommodation with delinquent borrowers may cost the fund little or nothing.

Although FHA-approved lenders and loan servicers already are required to pursue workout possibilities with delinquent borrowers, the penalties for noncompliance are limited to $6,500 per violation, with an aggregate $1.25 million exposure per year per lender for all violations. The new "treble damages" rule would authorize FHA to seek cash penalties equal to three times a lender's claim per loan on the insurance fund, with no dollar limitation per year. The new penalties would be on top of -- not in place of -- the existing penalties.

FHA's existing loss-mitigation policy successfully kept one-half of all delinquent borrowers out of foreclosure last year, according to Jackson. The new, tougher policy is intended to expand that percentage further.

Loss-mitigation or workout arrangements generally take several different forms:

• Mortgage modifications, in which the lender agrees to reduce the delinquent borrower's payments, and may also extend the payback period on the total debt.

• Special forbearance. This involves creation of a revised repayment plan, based on the borrower's financial situation and prospects. This may allow for a temporary suspension of payments or a temporary reduction in the monthly payment amount.

• Partial claim. This technique allows the lender to draw down a limited amount of money from the insurance fund to bring a loan current.

• Deeds-in-lieu of foreclosure. When a borrower's situation is so grave that no amount of forbearance or payment modification will cure the delinquency, FHA allows borrowers to hand over the deed to the house to the lender without a formal foreclosure. Though the borrowers lose their house, they avoid the long-time negative effects of a foreclosure on their credit records.

The net effect of the loss-mitigation and mandatory forbearance techniques is to give FHA-insured homeowners -- and their professional advisers such as Realtors, lawyers and nonprofit organizations -- more tools to keep their houses, even in the face of financial crises trigged by job loss, health problems or other family issues.

Published: April 19, 2004

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.