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FHA Sells Off Bad Loans, Outsources Principal Cuts

Cutting principal has been a toxic political idea at least since CNBC commentator Rick Santelli's Tea Party rant against the Obama administration's mortgage aid program. That's why the Federal Housing Administration is outsourcing the job to the private sector.

After selling 2,100 troubled single-family loans to private investors since 2010 in a pilot effort, the FHA is about to kick the effort into high gear. This week it will auction off in bulk 9,400 loans with $1.7 billion in unpaid balances, or $182,000 per loan.

About 40% are in four cities which already have large foreclosure backlogs — including Tampa, site of the Republican National Convention.

Introducing the program in June, Housing Secretary Shaun Donovan explained that a homeowner whose loan is sold might get a call from the buyer saying, "Hey, we're willing to cut your payment dramatically, or cut the balance on your loan dramatically. There are going to be a set of options that might arrive on that doorstep as the best news that homeowner has ever heard.

The bulk sales effort, the Distressed Asset Stabilization Program, offers yet one more chance for homeowners who have already been through all the administration's foreclosure-pre vention programs, to no avail.

It also may give the embattled FHA a cash infusion as it races to stay ahead of a tsunami of defaults stemming from the outsized role the agency took on to keep mortgage finance flowing starting in 2007.

FHA Needs Cash The FHA has taken several steps to try to avoid a politically awkward bailout. Since 2009, it has raised insurance premiums four times, with the latest taking effect in April. It's also moved beyond its traditional market of modest-income first-time homebuyers to serve higher-income borrowers with stronger credit profiles in what some see as "mission creep.

The agency appeared in danger of running out of cash before Bank of America (BAC) agreed in February to pay $1 billion to resolve faulty origination claims leveled against its Countrywide unit. (That was part of the $25 billion settlement with mortgage servicers over inadequate foreclosure documentation.) Fitch Ratings said last month that it expects FHA finances to worsen, possibly leading to "unconventional measures to boost reserves," such as taking "a more aggressive stance" in challenging banks over insurance claims on defaulted loans.

A November audit showed agency reserves of $2.6 billion vs. $4.7 billion a year earlier. Reserves amount to a mere 0.24% of $1 trillion in insured loans, far below the congressionally mandated 2%.

The bulk sales program may help the FHA avoid a cash crunch because it will get the sales proceeds at the same time it has to pay out insurance claims, instead of going through a long foreclosure process.

That's because the foreclosure pipeline is already stuffed in areas where the FHA has a high concentration of seriously delinquent loans.

Still, FHA cash-flow issues don't seem to be the primary motivation behind the program.

The bulk sales program is in character for an agency that has long been willing to "bend over backwards" to keep borrowers in their homes, said Mark Calabria, Cato Institute director of financial regulation studies.

The agency notes that investors have an opportunity to make a profit even while cutting principal or facilitating short sales because FHA auction prices are "generally . . . less than what the borrower currently owes.

That is an understatement. In its most recent test sale, the FHA unloaded $58 million in distressed mortgages for $19.4 million. That amounts to one-third of the unpaid principal balance, or 45% of the estimated fair market value of the properties.

The coming sales may fetch an even smaller share of unpaid principal. Beyond ensuring that investors delay foreclosure for a minimum of six months, the FHA added a limit that no more than 50% of loans packaged by area be subject to foreclosure.

"The more restrictions, the less money you are going to get," Calabria said.

In July, 725,000 FHA-insured loans, or 9.5% of the total, were at least 90 days delinquent.

Fitch notes that the low required down payment of 3.5% has left many borrowers with negative equity, which "is likely to exacerbate default and delinquency trends over time, as borrowers have reduced incentives to continue making payments."