The U.S. Department of Housing and Urban Development (HUD) has come up with both a carrot and a stick to reduce losses arising from FHA insured loans gone bad.

On April 26 HUD released information on a punitive approach to lenders that issue FHA loans and then fail to engage in loss mitigation efforts when those loans default. Then HUD announced a program to reward lenders who do utilize what HUD considers to be its most effective options for dealing with distressed loans.

On the stick side, HUD published a final rule that dramatically increased the financial damages that HUD can seek against lenders that fail to utilize its mitigation programs. Prior to the release of these rules, HUD could assess fines of $6,500 per occurrence up to a maximum of $1.25 million per year against lenders. The new rules provide for additional damages of triple the amount of any FHA mortgage insurance benefit claimed by a lender.

Then, three days later, came the carrot in the form of a financial incentive offered to FHA lenders to encourage use of these loss mitigation tools. The new rules will allow lenders to claim up to $750 for completing mortgage modifications and $500 for partial claims. This is an increase of $250 in each case.

Both the positive and the negative reinforcement techniques are meant to prevent foreclosures or minimize their impact on the FHA insurance funds and homeowners themselves. HUD claims that its loss mitigation techniques helped more than 78,000 homeowners keep their residences in 2004, a larger number than the sum of claims paid by FHA to lenders for completed foreclosures.

The FHA Loss Mitigation Program gives lenders the authority and responsibility to assist homeowners who have fallen into financial difficulties with their home mortgages. Lenders have the option of offering borrowers a number of HUD/FHA approved options for avoiding foreclosure:

  • Special Forbearance: This can include a temporary reduction or suspension of mortgage payments until the borrower can re-establish financial stability or a permanent revision in the payment amount to reflect a borrower's new and reduced financial status.

  • Modifications: The lender can rewrite the mortgage note in order to roll delinquent amounts into the principal or extend the term of the loan to reduce monthly payments.

  • Partial Claim: Under this program FHA's insurance fund makes a one-time payment to bring the mortgage current.

  • Pre-Foreclosure Sale: The borrower avoids foreclosure by selling the property for its appraised value even if this results in a "short sale," i.e., the proceeds are not enough to pay off the mortgage.

  • Deed-in-Lieu of Foreclosure: This is a negotiated settlement wherein the borrower deeds the house back to the lender, saving the FHA insurance fund some legal costs and the borrower all of the credit ramifications of a foreclosure.

HUD's press release states that the incentives, effective June 1, are offered to lenders to reflect the increased costs lenders incur when working out solutions to homeowners financial difficulties.