The Federal Deposit Insurance Corporation (FDIC) on Wednesday accepted a bid from a mortgage servicer for the residential loan portfolio of a failed Texas-based bank. The FDIC, explained two of its spokespeople, is using this deal to test the viability of a funding plan for its Legacy Loans Program, whose aim is to get nonperforming loans off of the books of still-solvent banks in order to get them to start lending again.

The Legacy Loans Program, which FDIC had postponed in June, was set up to encourage private capital to purchase toxic assets such as troubled mortgages. To this point, however, most bids from potential buyers, like hedge funds, have been significantly below the yields that the government has been seeking.

The deal it signed yesterday represents a new approach. FDIC formed a joint venture with Residential Credit Solutions (RCS), a Fort Worth, Texas-based mortgage servicer. The venture is a limited liability company that is purchasing the portfolio of residential loans that FDIC owns as the receiver of Houston-based Franklin Bank, which the government took over last November. The unpaid principal balance of those loans is about $1.3 billion. Approximately 30% of them are currently nonperforming.

RCS, whose “focus,” according to its Web site, “is to keep our mortgage customers in their homes,” will pay $64.2 million in cash for a 50% stake in the LLC. The FDIC, which is providing most of the financing for this deal, will own the other half of the LLC.

But instead of accepting cash for the loans it is conveying, FDIC will accept a $727.8 million note from the LLC. The government is guaranteeing the note and is lending the money to the LLC at a favorable 4.25% interest rate. Ultimately the government intends to sell this note to other investors, and its spokesmen said that it has already received “interest” from buyers they declined to identify.

RCS was one of 12 consortiums that made a total of 19 bids for the Franklin Bank portfolio, which was chosen for this test because its loan mix is similar to other portfolios that the FDIC might consider selling this way.

(FDIC has an estimated $30 billion in assets in receivership.)

The government estimates that the present value of the joint venture’s bid is equal to about 71% of the outstanding principal balance of Franklin’s portfolio. The agency’s officials conceded yesterday that without this funding mechanism, investors would probably have been willing to pay only about 50 cents on the dollar.

Spokesmen for the FDIC said that future tests are likely to include combinations of portfolios from different failed banks. But they were quick to note that the goal of the Legacy Loans Program is still to cleanse the balance sheets of still-functioning banks of “uncertain” loans so they can begin providing financing again to borrowers.

The receptionist at RCS’s headquarters told BUILDER that she had been instructed not to comment on this transaction. But FDIC spokespeople indicated that one of the reasons the government accepted RCS’s bid was because it is participating in the Home Affordable Modification Program, whose financing comes out of the $700 million Troubled Asset Relief Program (TARP). This mortgage modification (and foreclosure prevention program gives incentives to servicers to modify borrowers’ loans within government-issued guidelines.

But FDIC could have trouble finding other joint-venture partners in future loan purchase deals if participation in the government's mortgage-modification program is required. So far, only about 12% of distressed homeowners—360,165 out of 2.9 million—have had their loans modified through this program. Bank of America had modified only 7% of its borrowers’ loans through August. “We believe there is a general need for servicers to devote substantially more resources to this program for it to fully succeed,” wrote Treasury Secretary Tim Geithner and HUD Secretary Shaun Donovan in a pointed letter to bank CEOs in July.

In a separate move, FDIC on Wednesday released a free foreclosure prevention “tool kit” aimed at helping borrowers and lenders avoid “unnecessary” foreclosures, and stopping “scams” that have been promising “false hope to consumers.”

John Caulfield is senior editor for BUILDER magazine.

Learn more about markets featured in this article: Washington, DC, Dallas, TX.