FHA Insured Mortgages: A Disaster in the Making, Part 1

Includes: KME, PSR, VMBS, XHB
by: Keith Jurow

In a previous REAL ESTATE CHANNEL article, I pointed out that there were two main props supporting the housing market now. We examined the first one in detail – the banks withholding most foreclosed homes from the market.

The second prop is even more important – the soaring percentage of home mortgages that are insured by the Federal Housing Administration (FHA). Let’s take an in-depth look at the FHA.

A Little History

The Federal Housing Administration was created by Congress in 1934 to enable lower income families to purchase homes that they would otherwise not have been able to afford. Remember, this was only a year after the banking system totally collapsed and roughly 4,000 banks had permanently shut their doors. To encourage reluctant banks to write mortgages, the FHA was authorized to provide insurance for mortgage loans backed by the full-faith-and-credit of the United States.

FHA Insured Loans Saved the Housing Market From Collapse

During the housing bubble years of 2004-2006, the FHA played no role in supporting the boom. When the market finally seized up in the spring of 2007, the FHA made a determined effort to keep mortgage lending from completely drying up. The chart below puts this into perspective:

(Click to enlarge)

As of June 2010, the FHA had 6.4 million insured loans in force. Three and one-half million of them were put in place during FY 2008-2009. The total dollar amount of FHA insurance in place through June was $865 billion. At the current rate of insured loan originations, the total of insured loans in force will exceed $1 trillion within six months.

FHA Underwriting Standards

Although the FHA was essentially a non-factor in facilitating the housing boom, its standards for providing mortgage insurance have been extremely lax to say the least.

During his appearance before the House of Representatives this past March, the FHA Commissioner, David Stevens, submitted detailed written testimony which pointed out that 6.2% of the entire insured loan portfolio had been issued to homebuyers with FICO scores below 500. Really. That is roughly 360,000 insured loans which were provided to owners with FICO scores less than 500. Keep in mind that the accepted standard for subprime mortgages during the bubble years was a FICO score lower than 620. More than 37% of these loans are now at least 60 days delinquent, in foreclosure, or in bankruptcy.

Compounding the problem, between 2001 and 2008 the FHA provided a program known as seller-funded downpayment assistance (SFDP). It allowed non-profit consumer advocacy groups to “donate” the 3.5% down payment to low-income buyers seeking an FHA insured loan. The seller was often a home builder who “contributed” the funds to the non-profit which passed it on to the buyer.

The program was riddled with fraud. Many of the non-profits were really tools of the builders. To cover their costs, the builders simply jacked up the price of the home. In 2006, the Commissioner of the IRS called these mortgages “scams” which “damage the image of honest, legitimate charities.” After mounting criticism, the program was finally ended in 2008. The FHA actuarial report issued in 2009 calculated that the program had cost the Agency nearly $10 billion in losses.

Mortgage Modification Efforts

According to the written testimony submitted by Commissioner Stevens referred to earlier, the FHA assisted 450,000 families in keeping their homes out of foreclosure in FY 2009. For the first quarter of the current fiscal year, the Agency assisted another 122,000 families.

Unfortunately, the Mortgage Metrics Report issued jointly by the Office of Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) for the first quarter of 2010 revealed that 67% of these modified FHA mortgages were in default again within twelve months.

In spite of these increasing mortgage modification efforts, the number of seriously delinquent FHA mortgages (delinquent 90+ days) climbed to 555,000 in May 2010 according to HUD’s Neighborhood Watch database.

Protecting the FHA’s Capital Reserve Account

Because of the skyrocketing loan delinquencies and defaults, the FHA decided to take actions to protect its Capital Reserve Account. As the chart below shows, it had fallen below the required minimum of 2% by 2009:

(Click to enlarge)

In his March Congressional testimony mentioned earlier, Commissioner Stevens cited several steps the Agency was taking to shore up the Capital Reserve Account. First, he pointed out that it had cracked down on 354 FHA lenders by withdrawing their approval status.

This action was necessary because mortgage fraud had reared its ugly head again. The number of FHA-approved lenders had doubled between 2007 and 2009, but the Agency had neither the staff nor the resources to adequately police them. Evidence of widespread fraud had been uncovered by the Washington Post in early 2009. It reported that 9,200 loans insured by the FDA between 2007 and 2009 had gone into default after no more than one mortgage payment had been made.

To protect the Agency’s Capital Reserve Account, the Commissioner was increasing the upfront insurance premium from 1.5% of the amount borrowed to 2.25%. He also planned to raise the recurring annual premium from 0.5% to 0.9% for loans with loan-to-value (LTV) ratios above 95%. After the Reserve Account was restored to its 2% minimum, he planned to actually lower the upfront insurance premium to 1%. The Commissioner noted that these changes would have little impact on how much an applicant needed to expend up front because the up front premium was usually rolled into the amount borrowed.

Commissioner Stevens also stated that he was planning to create a two-tier FICO requirement. To obtain a loan that required only the minimum 3.5% down payment, an applicant would need a FICO score of at least 580. Those with scores of 500-579 would be required to make a minimum down payment of 10%. Applicants with FICO scores less than 500 would be ineligible for an FHA loan guarantee.

With regard to a proposal that the minimum down payment be raised to 5%, Stevens rejected the idea because it would “adversely impact the housing market recovery.”

>> Continue to Part 2

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