Govt to take the sting out of Short Sales and Foreclosures

The Obama administration wants to create a mortgage market that is more forgiving to borrowers who lost their homes due to the recession, an effort that could widen the pool of potential homeowners.

A recent rule change lets certain borrowers who have gone through a foreclosure, bankruptcy or other adverse event—but who have repaired their credit—become eligible to receive a new mortgage backed by the Federal Housing Administration after waiting as little as one year. Previously, they had to wait at least three years before they could qualify for a new government-backed loan.

To be eligible for the new FHA loans, borrowers must show that their foreclosure or bankruptcy was caused by a job loss or reduction in income that was beyond their control. Borrowers also must prove their incomes have had a "full recovery" and complete housing counseling before getting a new mortgage.

But it isn't clear if banks will be eager to offer loans with the new terms at a time when they are facing a wave of lawsuits and investigations related to other government-backed loans. The FHA already offers among the most flexible lending standards today, requiring down payments of just 3.5%.

"It's difficult to see how lenders would even consider doing mortgages with higher risk" in the current environment, said David Stevens, the chief executive of the Mortgage Bankers Association, who served as the FHA's commissioner from 2009 to 2011. Lenders aren't going to expand credit "while you're suing them and threatening them over minor errors."

The policy change reflects broader concerns among administration officials and federal regulators that the mortgage-credit pendulum has swung too far to the restrictive side from the days of lax lending rules that fueled the bubble. Some economists say too-strict credit standards are shutting out some creditworthy borrowers and holding back economic growth. Low participation in the recovery by young buyers "absolutely is a problem, and I'm not exactly an 'easy credit' guy," said Thomas Lawler, a housing economist in Leesburg, Va.

The new rules, which expire in three years, also apply to former homeowners who completed a short sale, where a bank approves the sale for less than the amount owed.

Shaun Donovan, the secretary for the Department of Housing and Urban Development, which runs the FHA, played down potential criticism that the agency might invite a return to risky lending practices. "What we are talking about is getting back to responsible, plain-vanilla lending," he said in an interview. "We believe these are low-risk loans that can be made safely."

In the four years ended last September, some 3.9 million homes had been lost to foreclosure. About 1 million borrowers who went through foreclosure during the crisis have already waited the required three years to be eligible for an FHA-backed mortgage, and by early next year that number could rise to 1.5 million, according to estimates from Moody's Analytics.

In speeches this year, officials at the Federal Reserve have raised concerns that tight lending standards could make it harder for younger borrowers, who tend to have lower credit scores, to obtain mortgages. The Fed's quarterly surveys of senior loan officers have found that while banks have indicated a growing willingness to extend credit to borrowers with high credit scores, about 30% of lenders in April reported that they were less likely than a year earlier to extend FHA-backed loans to borrowers with lower credit scores.

Still, not all lenders believe tight credit is the problem. Logan Mohtashami, a mortgage broker in Irvine, Calif., argues that weak income growth is a bigger problem. "Getting a loan done is a lot more work, but if you have the financial goods, you get the loan," he said.

But Mr. Mohtashami said he isn't concerned that the FHA rule changes invites a return to bubble-era excesses. "This can't be compared to subprime. The problem back then was that nobody was verifying anything," he said. "This still requires people to qualify for the loan, verify the job, verify the assets."

Write to Nick Timiraos at nick.timiraos@wsj.com