Banks may be left holding the bag on delinquent mortgages if they haven’t followed all the rules for loss prevention before foreclosing on Federal Housing Administration loans. According to an April 28 article in American Banker, non-compliant banks may not be reimbursed for billions of dollars of delinquent FHA-insured loans.

Even though the nation’s largest banks have said they expect reimbursement, they may not receive it if they have violated servicing standards.

At the end of 2010, Bank of America Corp. held $16.8 billion of loans insured by the FHA and the Department of Veterans Affairs that were 90 days or more past due. Wells Fargo & Co. had $14.7 billion, Citigroup Inc. had $9.3 billion and JPMorgan Chase & Co. held $8.7 billion, according to American Banker.

Most delinquent loans are still being worked out or are stuck somewhere in the foreclosure process, according to American Banker. The FHA pays claims only when a loan has gone into foreclosure and the property has been conveyed back to FHA.

Banks can be penalized up to three times the amount of any FHA insurance claim if they have not offered loss-prevention options to defaulted borrowers. The average claim submitted in 2010 was $167,782. Therefore, banks could face up to $500,000 in penalties for each claim if they have not provided loss-prevention options to the borrower.

Brian Chappelle, a partner in a consulting firm in Washington, D.C. and a former HUD official, told American Banker that lenders are uneasy filing claims while threats of penalties exist. “Lenders are really at a loss as to when the insurance stops and their responsibility starts,” he said.

American Banker reports that many banks have delayed submitting claims until they fully comply with consent orders issued by the Office of the Comptroller of the Currency earlier this year.  The order mandates an “overhaul of serving operations” and a third-party review of foreclosure for the past two years.

Industry experts expect a significant portion of penalties assessed on the largest banks will be paid to HUD for failing to extend appropriation loss mitigation options on delinquent loans. Some of the large banks are already in negotiations with FHA to avoid huge penalties, according to American Banker.

In the past two years, as delinquencies on FHA and VA-insured loans have risen, banks have been aggressive in buying delinquent loans from the Government National Mortgage Association, or Ginnie Mae. Funding delinquent loans on their balance sheets is cheaper than making regular principal and interest payments to bond investors, according to American Banker.

Most banks classify delinquent FHA loans as 90 days past due and still accruing interest, which some experts say is distorting bank earnings and overstating profitability.

Rebel Cole, a finance and real estate professor at DePaul University in Chicago and a former Federal Reserve Board economist, told American Banker the majority of the loans should be listed as nonperforming because reimbursement is not guaranteed. He said banks should not be accruing interest on the loans and should charge them off after 180 days.

"There is no certainty of reimbursement on these loans, but it's showing up as paper profits," Cole said. "FHA isn't recognizing the losses, and the banks aren't recognizing the losses, and they're all complaining about the deadbeat borrowers that they are not kicking out of their houses."