“The banks say they are certain of repayment but that’s simply not true,” says Rebel Cole, a finance and real estate professor at DePaul University in Chicago and a former Federal Reserve Board economist.

Buried in Fine Print: $57B of FHA Loans Big Banks May Have to Eat

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The nation's four largest banks are holding $57 billion of seriously delinquent loans that they've been slow to move into foreclosure over concerns that the Federal Housing Administration, the government mortgage insurer, will refuse to cover the losses and hit them with damages, according to industry sources.

The banks Bank of America (BAC), Citigroup (NYSE:C), JPMorgan Chase (JPM), and Wells Fargo (WFC) have assured investors in the footnotes of quarterly filings that the loans are government-insured and therefore pose no threat to their bottom lines, even if they end up in foreclosure. What's more, the banks have used these supposedly iron-clad government guarantees as a pretext for continuing to classify the loans as performing and for holding no reserves against them.

The FHA insures home loans issued by banks and other mortgage lenders to low-income and first-time home buyers. Those buyers pay the FHA insurance premiums to cover potential losses. In the event that an FHA-backed loan goes into foreclosure, the lender has the right to file a claim for reimbursement of losses.

However, the FHA's guarantee does not apply if lenders are found to have violated underwriting or servicing standards, or to have engaged in misconduct. Banks can also be held liable for treble damages under the False Claims Act if they are found to have "falsely certified" that mortgages met all FHA requirements.

As a result, the banks face hefty losses if the loans go into foreclosure because there is no guarantee that the FHA will cover them, asserts Rebel Cole, a former Federal Reserve Board economist who is now a professor of finance and real estate at DePaul University in Chicago.

In the last year, the Department of Housing and Urban Development, which oversees the FHA, has forced four banks to pay a total of $1.5 billion under the False Claims Act on FHA loans that defaulted. More settlements are expected soon.

"The banks say they are certain of repayment on these distressed assets, but that's simply not true," says Cole.

To be sure, even if all $57 billion of loans went into foreclosure, losses to the FHA and banks would likely be substantially less, thanks to recoveries on the properties. The FHA's overall recovery rate was 42% of the principal value in the second quarter.

Some lenders acknowledge that they will likely end up eating losses on defaulted loans held on their balance sheets and settlements related to past claims. They are also likely to try to avoid the risk of getting hit with damages by forgoing the FHA claims process and absorbing some losses themselves.

"There's a distinct possibility that they [banks] do not file all claims and just self-insure [absorb losses] on those loans," says Melissa Klimkiewicz, an attorney at BuckleySandler. "Lenders may err on the side of not filing claims where there is uncertainty because of the potential for HUD action or treble damages."

For their part, lenders bristle at the claim that they're intentionally keeping loans out of foreclosure. Even Ed Pinto, a resident fellow at the American Enterprise Institute and a sharp FHA critic, attributes the backlog of delinquent FHA loans to efforts by consumer groups to slow foreclosures, and to the unreasonably long time it takes to complete a foreclosure in states such as New York, New Jersey and Florida, where foreclosures are processed through the courts.

"Servicers are engaged in vigorous, robust loss mitigation efforts and that's one of the reasons foreclosures are taking longer and so many loans are still on (banks') books," says Phillip Schulman, a partner with the Washington office of K&L Gates, who represents several banks currently in negotiations with HUD.

"You can't file a claim until the house is in foreclosure or has [been the subject of] a short sale. It's a lengthy process, and foreclosure is the last option we look at," adds Jerry Dubrowski, a spokesman for B of A.

Moreover, it is not as if the FHA whose own financial health is in question is pressuring the banks to file claims. Like any insurer, the FHA wants to avoid paying claims, so it is providing incentives to mortgage servicers when they modify loans, offer a forbearance of past due mortgage payments or provide other alternatives to foreclosure. The FHA's goal is "to reduce the number of full claims against the insurance fund," a 2012 Government Accountability Office report on its finances said.

Some bank critics say they have intentionally held off from filing claims in the wake of their scandal involving the 'robo-signing' of foreclosure documents. That episode led to $25 billion national settlement between state attorneys general and the nation's five largest servicers. Critics suggest the banks are now unable to foreclose on FHA loans because they do not have proper documentation, and therefore cannot file claims with the FHA.

"It's like saying you'll be reimbursed for expenses when you've lost the receipts," says Reuben Guttman, who specializes in False Claims Act cases against banks at Grant & Eisenhofer.

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Comments (3)
Right now the industry is all about defense against an unyielding, overzealous, Monday morning second guessing regulatory environment.
I would also like to clarify your comment below regarding FHA targeted clients:

The FHA insures home loans issued by banks and other mortgage lenders to low-income and first-time home buyers

Back in the early 80's this was true but for over 20 years there is no income limit or restrictions to only first time buyers. This has provided more buyers the opportunity to own a home and improved FHA's balance sheet.
The talk now of going back to the old way of limiting income and restricting to first time buyers will severely weaken FHA by saddling FHA with only the highest risk loans.
Posted by markwhite | Tuesday, October 08 2013 at 2:25PM ET
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Posted by markwhite | Tuesday, October 08 2013 at 2:26PM ET
It is clear that that most of the sources in this article haven't spent a single moment in an actual foreclosure courtroom. I challenge anyone that wants to opine about the state of this industry or the reactions of the stakeholders and government handmaidens to come on down and spend a few hours just observing the chaos, the lies, the fraud and the catastrophe that continues to play out in actual courtrooms. One particularly irksome point is the common refrain, "the unreasonably long time it takes to complete a foreclosure"...well folks, if you spent time in courtrooms or communities you'd understand that it's your side of church that's causing most of the delays...again, the lies, the fraud, the chaos.
Posted by weidnerlaw | Tuesday, October 08 2013 at 9:53PM ET
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