ST. LOUIS (Reuters) – A senior U.S. Federal Reserve official said on Wednesday the central bank may start tightening financial conditions by adjusting its extensive purchase programs, rather than by raising interest rates.

"The market&&9;s focus on interest rates is disappointing, given quantitative easing," Bullard said, according to excerpts of remarks prepared for delivery to a group of bankers. "Markets should be focusing on quantitative monetary policy rather than interest rate policy," he said.

"The main challenge for monetary policy going forward will be how to adjust the asset purchase program without generating inflation while interest rates are near zero," Bullard said business card.

Medium-term inflation hinges on what the Fed will do with this program, he said.

The Fed has committed to buy up to &&6;1.725 trillion in mortgage-related securities by the end of March.

Inflation is still low, but commodity prices are volatile and uncertainty over inflation is elevated compared with the fall of 2008, Bullard said.

The expansion of the Fed&&9;s balance sheet has helped restore financial health after the crisis, but it creates an inflation risk, he said.

(Reporting by Mark Felsenthal, Editing by Chizu Nomiyama)

Fed's Bullard: Shrinking reserves key to exit

SAN DIEGO (MarketWatch) -- The Federal Housing Administration is considering a variety of changes -- including requiring larger down payments for FHA-insured mortgages, demanding higher credit scores of FHA borrowers and upping FHA mortgage premiums -- to manage risk as it deals with losses in its capital reserve fund, FHA Commissioner David H. Stevens said Saturday.

"Nothing is off the table," Stevens said at the National Association of Realtors' annual conference, being held in San Diego this weekend. "I will consider everything, and I've already made several risk changes to manage the portfolio."

Yet while there is concern about the FHA's finances, its situation doesn't resemble the losses seen in the subprime mortgage market, he said.

A report released in the past week showed that the FHA has sustained significant losses from loans made before this year, as the country's foreclosure problem deepened. Its capital reserves have fallen below the threshold mandated by Congress.

By law, FHA must have two reserve accounts, Stevens explained to the Realtor audience. One is to hold funds to pay all forecasted losses, he said.

Then, "there's a secondary account, it's an excess valve that is used to pay unforecasted losses," he said. The creation of the secondary account is why FHA is "still standing while many others did not survive this tumultuous time," he said.

That secondary account is also the cause of concern.

The independent study projected that the secondary account was 0.53% of the total insurance in force this year -- below the 2% statutory threshold, according to a news release from the U.S. Department of Housing and Urban Development. That said, by combining both accounts, FHA holds $31 billion in reserves, or more than 4.5% of total insurance in force.

The study concluded that under most economic scenarios, the FHA's reserves would remain above zero. Still, some have compared FHA's troubles to those that brought down the subprime market -- a comparison Stevens says isn't fair.

Stevens said quality of FHA loans is much better than risky subprime products that became popular during the real-estate boom.

FHA-backed mortgages are for principal residences, borrowers have to fully document their income, and nearly all of them are 30-year fully amortizing fixed-rate mortgages, he said. That contrasts with poor performing subprime and Alt-a loans that required little if any income documentation and often involved low teaser rates that skyrocketed when the introductory period was over, he said payday loans with no fax.

And recently, the overall credit quality of FHA borrowers has crept up: The average borrower's FICO score today is 693, compared with 633 two years ago.

Even though FHA is considering a variety of ways to address the reserve situation, Stevens also said it's important not to jump to conclusions and "overcorrect."

"I am modeling everything right now and looking at impacts. If you are concerned about defaults in the FHA portfolio, there are only a few primary areas that you can look at. One is the [mortgage insurance] premium, second is the qualifying guidelines -- the credit score and the down payment," he said in an interview following his speech.

"But we're doing it all with an eye on our No. 1 priority, which is to get the housing market back on track ... getting stability back in the housing system is the most important thing," he said.

Those in the real-estate industry are concerned about any action that would reduce available mortgage money. If down payment requirements for FHA rise, for example, that will take some prospective buyers out of the market and slow a recovery, said Helen Hanna Casey, president of Howard Hanna Real Estate Services, during an earlier panel on Saturday.

To give an idea of FHA's recent popularity, half of the FHA's current portfolio was originated this year, Stevens said.

In the second quarter, nearly 50% of all first-time buyers in the market used a loan insured by the FHA. FHA-insured loans typically require a 3.5% down payment, which can be helpful for those buying their first home.

FHA backed about $360 billion in mortgages in 2009 and forecasts it will back $400 billion next year, Stevens said.

But FHA won't play this large of a role in the lending market forever. And it shouldn't, Stevens said.

"We are a counter-cyclical provider of capital to the housing finance system, and for it to be this large is concerning to everyone in the administration. We're filling the role and will continue to fill the role, but ultimately have to be concerned about private capital returning to the system," Stevens said.

FHA considering changes in wake of reserve losses