Tuesday, April 22, 2008

The Mortgage Mess - FHA's Risky Business

Joshua Zumbrun and Maurna Desmond

In the wake of the subprime mortgage debacle, who on Earth would loan to "first-time home buyers whose high rents left them strapped for cash" or borrowers "with strong current incomes but not a lot of savings"? Wells Fargo says it will--with a little help from the federal government.
Touted as a savior in the housing crisis by Congress and the White House, the Federal Housing Administration is being turned into a bank's best friend. Major U.S. lenders are again aggressively enticing risky borrowers, offering FHA-backed mortgages with attractive terms and as little as 3% down. Meanwhile, the agency watches as its liabilities balloon.
As a result, the nation's mortgage market is quietly undergoing a radical and potentially risky transformation that shifts liability for hundreds of billions of dollars on to the government's books.

"FHA delinquencies tend to be quite high," says Alex Pollock, a fellow at the American Enterprise Institute and former president of the Federal Home Loan Bank of Chicago. "They are substantially higher than the prime market--not as high as the subprime market, but nonetheless quite high. You're in a sector of the market that is by definition risky."

Bill Glavin, special assistant to FHA Commissioner Brian Montgomery, says the FHA has been "inundated" with requests by business-strapped banks to become FHA-certified lenders. He expects the FHA to increase loan volume by 168.2% in fiscal year 2008 (ended September 30), insuring 1.14 million loans, up from 425,000 in 2007. The agency expects to guarantee $224 billion worth of loans in 2008.

On Thursday, Ginnie Mae--a government-owned company with more than two-thirds of its securities portfolio comprised of FHA-backed loans--announced a 114% surge in volume. They issued $39.1 billion in the first quarter of 2008, up from $18.3 billion during the same period last year. The company also expects its total portfolio of outstanding securities to grow to more than $600 billion by the end of the year, reflecting a 35.2% increase from the $443.8 held by Ginnie in 2007.

From Wells Fargo (nyse: WFC - news - people ) to Countrywide (nyse: CFC - news - people ), lenders see opportunity, driving the numbers. Bank of America (nyse: BAC - news - people ) Government Lending Executive Allen Jones says his company is "actively promoting" FHA-insured loans through "all of its sales channels." Jones expects the percentage of BofA mortgages insured by the FHA to be 30% to 35% by the end of the year, up from just 2% in 2006.

The FHA's growing role in the mortgage market "will clearly fill the void of subprime financing," says Vicki Wagner, an analyst at Standard & Poor's. Wagner said an FHA loan "by definition, looks and acts like a subprime loan."

The FHA's admirable, longstanding aim, of course, is to help home buyers snag keys to their American Dreams. Throughout the housing boom, more than 80% of FHA-insured loans went to buyers with less than 5% equity in their homes. In the early years of the boom, this was a safe bet. A $200,000 home might be purchased with a $190,000 loan--a 95% loan. In a few years, the home price might rise to $250,000, meaning the borrower has a 25% equity stake in the home. That's about the same portion of a loan that a private mortgage insurer would vouch for, even though FHA backs its loans 100%.

Unlike private mortgage insurers, the FHA requires an up-front premium, providing an extra cushion to cover its costs. Another difference from the worst of the online click-and-borrow hucksters: FHA's government-backed mortgages require income and asset documentation and have real underwriting rules. The FHA Secure program, through which subprime loans can be refinanced into FHA-insured loans, is only open to owner-occupied housing; properties purchased by speculators hoping to flip a home quickly amid rising prices are unable to benefit.

In July, the FHA celebrated these prudish lending practices, which had resulted in half the foreclosure rate of commercial subprime lenders. (See "Mortgage Lending's Benevolent Bureaucracy.")

But as the housing market melted, politicians looking to soften the blow turned to the agency for help. In August, President Bush announced a program expanding the FHA so an additional 240,000 risky borrowers could benefit from its mortgage insurance program this year alone. The program also altered the code to help borrowers refinance their loans with FHA insurance. (See "This Is Not A Bailout.") Then, in February, a congressional stimulus package allowed the FHA to increase its loan maximum to 125% of a market's median value, up to $729,750 from $362,790 for single-family homes.

Now legislators have proposed allowing borrowers unable to pay off the full value of their loans to reduce their debt to fit their home's diminished market value, backed by FHA insurance. If a lender were to foreclose, it could not recover more than this value anyway. With FHA insurance, the argument goes, everyone gets an incentive to refinance. (See "Third Way For FHA.")

Combined with a credit-starved mortgage market, the moves resulted in 87.8% growth in government loan applications from Aug. 3 to April 4. Conventional loans averaged just 12.6% growth during the same time.

The FHA estimates that, ultimately, 500,000 borrowers will avail themselves of the refinancing program announced in August and expanded earlier this month. Thus far, the average refinancing has been $190,000. If this average remains constant, the FHA portfolio would increase by $95 billion. In fact, this estimate may be low: The average loan price is likely to rise, as the ceiling on these loans was raised by the Economic Stimulus Act, making even more expensive loans eligible.

The FHA's default and delinquency rates fall between subprime and prime rates. In the Mortgage Bankers Association's most recent National Delinquency Survey, FHA foreclosure starts stood at 0.91%, much higher than the 0.22% rate for prime fixed-rate loans, but much lower than subprime fixed-rate loans at 1.52% and subprime adjustable-rate mortgages at 5.29%.

In 2007, the FHA's liability for loan guarantees amounted to $7 billion, an increase from $3 billion in 2006. With its portfolio continuing to increase, this liability will rise, but so will income from its initial premiums. In the FHA's report to the Office of Management and Budget, the FHA projected its premiums would continue to cover its liabilities in 2009, but only narrowly.

FHA only provides "guidelines" for who can benefit from an FHA loan. Glavin said the agency allows individual lenders to independently define what a "first-time home buyer" means, and also to decide whether a borrower is creditworthy.

FHA loans have no minimum credit score and no income cap. The only rock solid requirement is a 3% down payment; some politicians are also proposing to lower this to 1.5%, and others advocate zero payment.

Regardless of credit risk or how much equity a homeowner has, FHA borrowers pay a flat initial premium of 1.5%. On a $200,000 loan, the premium works out to $3,000. The borrower then pays an annual premium of 0.5%, in this case, $1,000 a year.

But while 0.5 % is also a fairly standard insurance rate in the private mortgage insurance market, the FHA does not have an average portfolio of borrowers. Once home prices stopped rising, FHA continued insuring homes with less than 95% equity. In 2006 and 2007, the insuring of homes with minimal equity continued--75% and 78% of the loans it insured were in this high-risk group.

The FHA is pressing Congress for permission to adjust insurance premiums to reflect risk. Glavin said that with increased volume, the inability to factor in the likelihood of default could create real solvency problems for the FHA down the road.

Nonetheless, the Department of Housing and Urban Development defends the FHA's practices.

"It's reasonable risk and it's compassionate, given the circumstances that we find ourselves in," says HUD spokesman Brian Sullivan.

Taxpayers had better hope he's right. As FHA's Glavin points out: "Now that subprime financing has dried up, you will see more of those borrowers in FHA loans--because we are virtually the only game in town."

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