WASHINGTON (Reuters) - A top U.S. banking regulator unveiled a plan on Friday to prevent about 1.5 million foreclosures, breaking ranks with the Bush administration by demanding bailout funds be diverted from banks to consumers.

The Federal Deposit Insurance Corp said the plan would modify millions of delinquent mortgages and the government would reward participating lenders by sharing the cost of defaults on restructured loans.

The dispute over housing policy during the administration’s final weeks spilled into the public as a the President George W. Bush administration renewed its opposition to using money from the $700 billion bailout fund to support such a foreclosure-prevention program.

“The FDIC proposal at the end of the day is a spending proposal,” Treasury Interim Assistant Secretary Neel Kashkari told a Congressional hearing on Friday.

Kashkari said the Troubled Assets Relief Program (TARP), which the Treasury controls, was designed for making investments in the financial system, not giving aid.

FDIC Chairman Sheila Bair spent weeks lobbying Bush administration officials to fund her plan through TARP before announcing the initiative.

“I have never seen anything like this,” said John Douglas, a former FDIC general counsel who is now a partner at law firm Paul Hastings Janofsky & Walker. “This is extremely unusual for an agency to get out in front of the administration like this.”

Viewed narrowly, Bair’s responsibility is to protect the solvency of the nation’s bank insurance fund -- the pot of money that is used to protect depositors if a bank fails. Bair is taking an uncommonly broad view of her role and has become a consumer crusader through the housing crisis.

Douglas said that Bair does not have the power to unilaterally implement the foreclosure plan but that her approach is gaining currency.

“She certainly has a lot of cover from Democrats and even some Republicans,” he said.

REGULATORY TENSION

Kashkari said Treasury Secretary Henry Paulson thinks the FDIC proposal “is a very interesting idea” and urged Congress to consider drafting legislation to create such a program. [nN14430931]

The White House said it is carefully reviewing the FDIC plan, but that it has to think about its potential cost.

The FDIC said its plan would cost the government about $24.4 billion, which could be paid from the TARP. Most of the money from an initial disbursement in that program has been injected as capital into banks.

The FDIC issued the proposal two days after Paulson publicly dismissed the idea.

Leading Democratic lawmakers have rallied behind Bair, a Republican, and have even pushed for her to have a place in Democratic president-elect Barack Obama’s administration.

The FDIC pushed forward with its plan, posting it on the agency's Web site on Friday morning (here).

“Although foreclosures are costly to lenders, borrowers and communities, the pace of loan modifications continues to be extremely slow,” the FDIC said.

Still, Douglas said, Bair’s bold plan might obscure the fact that modifying mortgages is a complicated business.

Litton Loan Servicing, one of the nation’s largest servicers for subrime loans, has found that more than one in four home loans that go into foreclosure have already been abandoned by the borrower.

“Many times these homeowners did not respond to loan modification offers and have simply walked away from their homes,” Larry Litton, Jr., the company’s president, told a Congressional panel on Friday.

“This sort of approach can create all sorts of incentives for people to change their behavior and look at their mortgages differently,” Douglas said of Bair’s proposal.

Eligible borrowers would include those who have missed at least two monthly payments on loans for homes they live in. Lenders would be expected to lower those borrowers’ monthly payments to about 31 percent of the borrowers’ monthly income.

The plan is modeled on the FDIC’s program to modify distressed mortgages at failed lender IndyMac Bancorp Inc, which the agency seized in July.

The federal government has laid out a number of plans in recent months to try to help distressed homeowners, the latest of which came earlier this week. On Monday, the federal overseer of mortgage giants Fannie Mae and Freddie Mac said the companies’ struggling borrowers can apply to have their mortgage payments lowered to 38 percent of their income.

The FDIC has said those industry-led efforts have not gone far enough, and that $24 billion in federal money should be spent on the mortgage guarantee program.