Capitol Hill is buzzing over a surprise proposal last week from a top federal banking official to provide low-cost "gap" financing to home owners stuck with loans that were unaffordable from the start.

The plan comes from FDIC chairman Sheila Bair, and coincides with House and Senate negotiations to use the FHA as the prime federal vehicle to assist troubled homeowners.

Ms. Bair's concept would sidestep FHA and turn the Treasury into a gap financing resource to reduce struggling homeowners' principal balances by as much as 20 percent for the next five years.

The program would be limited to borrowers who could qualify for reduced fixed rate payments at an affordable 35 percent debt-to-income ratio and are committed to staying in their homes and avoiding foreclosure.

The FDIC says the program would not cost the Treasury anything because participating lenders would pay five years worth of interest costs up front to the FDIC on the gap financing. After that, borrowers would pay interest -- at low Treasury borrowing rates -- for the balance of the term of the mortgage.

The FDIC gap loan would receive super lien status -- its debt would be paid off before the lender's in the event of a sale or foreclosure.

Here's an example provided by FDIC on how the concept would work: Say a borrower took out a "2/28" ARM that now has a $200,000 balance at 8 percent. Current principal, interest, taxes and insurance come to $1,744. With a monthly household income of $3,500 the loan is unaffordable because the owner's debt-to-income ratio is about 50 percent.

Under the FDIC plan, the mortgage lender would apply for a gap loan from the FDIC on the borrower's behalf to reduce the current mortgage balance to $160,000 at a fixed rate of 5.8 percent. The lender would pay the first five years of interest on the $40,000 in gap financing to the FDIC in advance.

This would allow the borrower to pay a more affordable $1,222 a month on $160,000 -- a 35 percent debt-to-income ratio -- and to pay no interest on the gap loan during the first five years.

Starting in year six, the homeowner would have to begin paying off the FDIC loan at an extra $235 a month.

The idea, says Bair, is to leverage low Treasury borrowing rates to help certain borrowers get over the hump and into smarter, fixed-rate loans.

The plan wouldn't help everybody, she agrees, but it could help up to 1 million homeowners who don't quite fit into any of the relief plans currently being crafted on Capitol Hill.

We'll keep you posted.

Published: May 5, 2008

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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, consmer 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.