New Mortgage Plan Floated

Underwater Borrowers Current on Payments Would Get Help

By RUTH SIMON, NICK TIMIRAOS and DAN FITZPATRICK

(See Corrections & Amplifications item below.)

State and federal officials are pushing a plan that could help some “underwater” borrowers get refinancing assistance in the latest government bid to break a legal impasse with big banks over alleged foreclosure abuses and ease problems in the housing market.

The proposal was raised in a meeting last week between government negotiators and giant lenders as part of an effort to settle allegations of questionable foreclosure practices. Discussions are still fluid and any final outcome is uncertain. Talks between government officials and the banks are expected to continue this week.

The plan under consideration would make refinancing available to some borrowers whose houses are worth less than their loans, so long as they are current on mortgage payments, according to people familiar with the matter. Such borrowers typically aren’t able to refinance because they lack equity in their homes. The plan would apply only to mortgages owned by the banks. It isn’t clear how many of those borrowers would qualify for help. Around 20% of all U.S. mortgages are owned by U.S.-chartered commercial banks; the majority are held by investors in mortgage-backed securities.

Federal officials have been trying to broker a settlement with the five largest mortgage servicers—Ally Financial Inc., Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co.

The plan is designed to win the support of California Attorney General Kamala D. Harris, who bolted from talks between the banks, states attorneys general and federal officials a few weeks ago. She had called a prior version of the deal “inadequate.” Without California’s participation, it will be difficult for the government to reach a settlement of $20 billion to $25 billion that some state and federal officials have been seeking.

As for the new plan, a spokesman for Ms. Harris said “we haven’t seen any such proposal.”

Administration officials have viewed the broader foreclosure settlement as an opportunity to increase the number of financially troubled borrowers who receive principal reductions, which until now banks have granted only on a limited basis, and to provide those at risk of foreclosure with other assistance.

Home prices have fallen by nearly a third over the past five years, leaving many homeowners owing far more than their home is worth, a problem that threatens economic growth for years to come.

Three-quarters of all borrowers who are underwater, amounting to around eight million homeowners, have “above market” rates and could reduce their mortgage rate by at least one percentage point if they were able to refinance, according to CoreLogic.

Housing and Urban Development Secretary Shaun Donovan joined two days of discussions last week, the highest-profile Obama administration official to participate in the talks, which also include state attorneys general and the Justice Department.

While Mr. Donovan’s involvement initially led banks to believe that final decisions could be reached with state and federal officials, several bank executives grew frustrated with what they saw as last-minute efforts to change technical but important details that they believed had already been settled, people familiar with the matter said.

Friday’s discussions became very heated at times, people close to the negotiations say. Government negotiators “have no idea how frustrated the banks are,” said one person close to the banks.

An administration official conceded that the discussions have grown more “intense” as banks and the government attempt to narrow remaining differences, but characterized banks’ concerns as part of the normal course of finalizing a difficult negotiation.

Supporters of the refinance proposal say it would provide a boost to the economy and benefit borrowers who have worked hard to stay current on their loans, even though they owe more than their home is worth.

The refinance program would be particularly costly for banks because they would be forced to give up expected interest income on loans for which borrowers are current on their loan payments and, given their payment histories, unlikely to default. Banks can’t reduce rates on loans they don’t own because the result would be a net loss to the investor.

“Nine months ago this would have been inconceivable,” said one person familiar with the banks’ thinking.

Representatives of Ally, Bank of America, Citigroup, J.P. Morgan and Wells Fargo declined to comment on the negotiations.

In a speech to the Mortgage Bankers Association last week, Mr. Donovan said a settlement would help banks avoid “hundreds of different lawsuits with varying degrees of success,” while benefitting “struggling homeowners now, not sometime in the future.”

The administration’s efforts to revive the housing market and aid distressed borrowers have been overwhelmed by a sluggish economy and stubbornly high unemployment. The government’s loan-modification and refinance initiatives have reached fewer borrowers than expected.

Under the new proposal, banks would refinance certain borrowers who are current on their loan payments, but can’t qualify for a traditional refinance because they owe more than their homes are worth.

Many key details remain to be sorted out. It’s not clear, for instance, whether borrowers would receive a permanent rate cut or whether their rates would be lowered for several years, then move higher.

Allowing more underwater borrowers to refinance could have an outsize impact in California, which has more than two million underwater borrowers, more than any other state, according to CoreLogic data. It’s not clear how many underwater borrowers are current on their loan payments or how many of their loans are held in bank portfolios.

The new proposal has complicated discussions because the banks want a broader release from additional legal claims in exchange for accepting the refinance proposal, sources familiar with the negotiations say.

The two sides have differing opinions as to whether adding the refinance component would increase the price tag for the deal, these people add.

The refinancing discussion is separate from a parallel effort by the Obama administration to expand an existing federal program that allows homeowners to refinance if they have little or no equity and their loans are backed by Fannie Mae and Freddie Mac, the government-controlled housing giants.

The administration and federal regulators are preparing to unveil changes to that program as soon as this month to remove technical barriers that have blocked many eligible borrowers from participating.

Write to Ruth Simon at ruth.simon@wsj.com, Nick Timiraos at nick.timiraos@wsj.com and Dan Fitzpatrick at dan.fitzpatrick@wsj.com

Corrections & Amplifications

A new government proposal calls for only refinancing assistance for certain homeowners who are current on their mortgage payments but owe more than their home is worth. This article incorrectly said it would include principal reduction.