Government officials are likely to lessen large banks' liabilities over how they handled delinquent Federal Housing Administration-insured mortgages as part of a settlement with the largest mortgage servicers, according to people briefed on the negotiations.

The Department of Housing and Urban Development has offered to release banks from liability relating to their loss-mitigation efforts on delinquent FHA-insured loans, the people said. The offer would apply to certain liabilities related to banks' servicing practices, but it is unclear whether the settlement would also provide relief from claims related to mortgage originations.

The current settlement proposal is the latest proffer in the long-sputtering negotiations between state attorneys general, federal officials and mortgage servicers. The talks are focused on the banks' controversial foreclosure-related practices, including so-called robo-signing of foreclosure documents. The parties to the talks are aiming to resolve their differences by Christmas, several people briefed on the talks told American Banker.

The government has stepped up its scrutiny of how large banks handle FHA-insured loans. It sued Deutsche Bank in May for $1.2 billion, alleging underwriting and quality-control violations. That lawsuit raised the threat of similar actions against other large banks, including Bank of America Corp., Wells Fargo & Co., Citigroup Inc. and JPMorgan Chase & Co., which hold billions of dollars each of delinquent FHA-insured loans.

Now federal officials are offering banks a way to limit some potential liabilities. Currently, if a bank submits a mortgage-insurance claim to the FHA and HUD finds evidence that the underlying mortgage was improperly handled the bank can, under the False Claims Act, be held liable for treble damages, or fines that amount to three times the sum of the original claim submitted by the lender.

As part of broader settlement talks over the banks' questionable mortgage practices, HUD would release banks from that liability and not seek fines from banks relating to some parts of the FHA-insured mortgages they currently hold, sources say.

That offer could save big banks billions of dollars each in potential legal settlements and fines related to claims that they failed to follow proper loss-mitigation procedures on delinquent FHA-insured mortgages, according to people briefed on the talks. The liability release may be limited to certain mortgage originations made between 2006 and 2009 and would not include a release from liability for fraud or violations of representation and warranty claims, one of the people says.

Clinton Rockwell, a partner with the BuckleySandler LLP law firm, said a release from liability could be "a good thing" for banks — depending on the nature of the remaining settlement terms.

"Loss mitigation and treble damages issues are certainly on everyone's radar screen as a big deal," says Rockwell, whose firm represents banks. "But it all depends on the structure of a settlement. Does the fact that HUD is making this deal mean only some aspects of servicing are covered, but not underwriting? And how would that affect other branches of the federal government? It's certainly a moving target."

A HUD spokesman declined to comment on the settlement talks.

HUD's offer may not end the months-long standoff. Efforts to reach a settlement with the mortgage servicers have been stymied, in part, by the disparate expectations of various state attorneys general involved in the talks. The banks also lost an incentive to negotiate when key officials, including the attorneys general of California and New York, left the talks. Even if the negotiations lead to an agreement, it would likely still require the banks collectively to pay out between $20 billion and $25 billion.

By granting tangible benefits to banks that sign on, HUD's offer could act as an important sweetener for completing a deal. If a settlement is reached that allows the banks to avoid some liability risk from FHA-insured loans, the banks would avoid a potentially significant flurry of future lawsuits — and be able to reassure investors that they have less long-term risk hanging over their operations.

Bank of America Corp., Wells Fargo & Co., JPMorgan Chase Inc., Citigroup Inc. and Ally Financial Inc. reported a combined $58 billion in FHA and Veterans Administration-insured mortgages at Sept. 30 that were either 90 days past due or otherwise impaired, and that had been repurchased and placed on their balance sheets or were eligible for repurchase. B of A had $25.6 billion of such loans; Wells Fargo had $15.7 billion; JPMorgan Chase had $9.6 billion; Citigroup had $4.5 billion; and Ally had $2.4 billion.

Wells Fargo has a "relatively low historical claim rate at FHA," says spokesman Tom Goyda. Representatives for B of A, JPMorgan Chase, Citigroup and Ally said they expect to be reimbursed for any losses on delinquent FHA-insured loans, but declined to discuss the matter further.

For two years, banks have been aggressively repurchasing delinquent FHA-insured loans from securities pools held by the Government National Mortgage Association, or Ginnie Mae. Buying the delinquent loans and holding them on their balance sheets is generally cheaper than making regular principal and interest payments to bond investors.

When banks buy the FHA-insured loans from Ginnie Mae, they receive insurance certificates from HUD ensuring reimbursement for losses. But if HUD finds that the banks mishandled the loans, the agency can force the banks to cover the losses themselves, thus indemnifying the FHA's insurance fund.

HUD wields a large hammer against lenders because it can suspend or terminate a lender's ability to originate FHA loans, says Rockwell of Buckley Sandler. The federal agency can also rescind its insurance on loans already made.

"The biggest deal is to make an FHA-insured loan and find that, because of an error, the insurance is effectively no longer good," Rockwell says. "That's the ultimate penalty … you made a bunch of loans that are no longer insured by the federal government."

The agency's latest offer would make it easier for the banks to ramp up foreclosures on defaulted FHA-insured mortgages. Banks have held off from filing many claims on those loans with HUD, because they have wanted assurances that they will not be charged or fined for related foreclosure and mortgage servicing abuses.

"Hopefully we'll get to some resolution soon, so everybody can start filing claims," says one executive at a bank involved in the settlement talks.

The average claim banks submitted to HUD last year was $167,782, so banks could potentially face up to $500,000 in penalties for each claim if it were rejected for failing to provide proper loss mitigation.

In its annual report to Congress this month, HUD acknowledged that banks hold a "large number of loans that have already gone through a foreclosure auction but have not yet gone to claim."

HUD said in the report that loan servicers "are purposefully delaying filing claims until actual or potential challenges to the foreclosure actions are resolved."

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