So apparently the subprime mortgage crisis did not teach us much about the mortgage products we originate. FHA loans have replaced the subprime loans that caused the financial crisis and economic recession, and it is my opinion that they are not much better. FHA loans are loans that banks can issue and that the government will 100% insure so long as they qualify under FHA guidelines (which don’t seem to be to strict). So lets compare:
Characteristics of a subprime loan:
Stated Income Stated Assets: Mr. Jones might make $60K a year but “state” that he makes $100K a year and qualify for a larger mortgage. Originally this type of program was designed for borrowers who earned 1099 income and did not disclose their actual income on their tax returns for obvious tax purposes. Therefore the borrower did in fact make enough income to pay for a higher mortgage they just didn’t have the documentation to prove they made a higher income. In turn the bank charged them a slight premium for not providing full documentation of their income. Although this seems sensible initially, it turned out to have many problems. Namely, 1099 income is not always consistent and therefore on a bad month Mr. Jones might have trouble paying for his higher mortgage. However, the bigger problem is that these mortgages were issued to people who had W2 income. So for example Mr. Jones works as a hospital worker and makes 35K a year however he tells the bank that he also does construction side jobs on the weekends. The bank says ok Mr. Jones for get about your W2 income we won’t prove how much you make we’ll just state that you make 60K a year and you will qualify for the nicer house you were looking to buy. Mr. Jones says, “heck ya, let’s do that”, I’ll just work a few extra jobs on the side and I’ll be able to afford the mortgage.
The bank is happy because they just sold a larger loan amount. They don’t really care if Mr. Jones makes his payments because they will sell his mortgage to an investor in a week. The investor who buys Mr. Jones’ mortgage from the bank doesn’t care because he doesn’t actually know what went on behind the scenes, he thinks Mr. Jones in deed makes 60K a year and along with other characteristics will simply pool Mr. Jones mortgage without even looking at, with a bunch of other mortgages and create a debt security and make money.
Other banks that would have kept Mr. Jones mortgage or cared whether or not he made payments issued the loan anyway. Their thinking was: well if Mr. Jones defaults and we have to foreclose (which we don’t want to do) but if we have to, property values are rising so the equity in Mr. Jones’ house will be sufficient enough for us to re coop our losses and be on the upside in case of foreclosure.
This was probably the biggest characteristic of subprime mortgages that caused the subprime mortgage crisis in terms of default. FHA loans require full income documentation however the following characteristics of FHA mortgages are very similar to subprime loans and in my opinion make them very risky, and way to risky to be handing out like candy.
The second characteristic to subprime mortgages is the substandard credit worthiness of the borrower. FHA loans just like subprime loans are given to borrowers with poor credit scores (borrowers with good credit scores get prime loans not FHA). To illustrate how substandard… Mr. Jones can have a 560 FICO score due to lates, charge offs, liens, lates on his mortgage etc. and still be approved for a 300K FHA mortgage. In my opinion if somebody had that much trouble paying their debts to have a 560 credit score, I would think twice about giving them a loan for 300K.
Another characteristic of subprime loans is high LTV ratios. When a loan on a property is greater than 80% of the total value of the loan it can only qualify as a subprime loan. Again similarly FHA loans lend at very high LTV ratios. To illustrate FHA loans are commonly issued at 97% LTV and even go as high as 105% (???) thus, on a 300,000 mortgage in case of foreclosure the bank only has 9000 in equity to re coop its transaction costs assuming they are able to sell the property at 100% of its value (which is highly unlikely). $9,000 does not even begin to cover the transaction costs associated with a foreclosure of this size.
In my opinion based on their credit scores and LTV ratios borrowers of FHA mortgages are very risky. With a 560 credit score I feel you have a very high propensity to default on your mortgage. Say they loose their job (which is highly likely in today’s economy), it is twice as likely they will stop making their payments. Now the bank has to come in and foreclose. At 97% LTV they will easily be under water, in terms of net proceeds from the transaction, 97% of the time they foreclose on a property. But the bank doesn’t care because they will just file a claim with FHA insurance, and the government will pay them for their losses.
We can see how unhealthy these loans are now; already the government insurance payouts on claims on FHA loans far exceed the money coming in. So if this is the case now, can these loans lead to another crisis, and if they do what will be the solution then?
If it becomes a crisis like the subprime mortgage crisis it will be solely the responsibility of the government to be the first liable since they are insuring all these mortgages. Whereas with subprime mortgages, first the banks were liable and when they weren’t able to handle it the government came into to help. So what will the government have to do to make good on these insurance claims? Print more money… if a crisis were to happen anytime soon and the government were to print more money to cover these claims, given the monetary policy impact lags, the extent of QE1+QE2 + new money printed to pay for claims, will have to have tremendous repercussions on inflation. It is scary to think what the magnitude would be. So the question is if these loans are so risky in my opinion almost as risky as subprime mortgages in today’s economy, why are we giving these mortgages out like they are candy. Wouldn’t history teach us to become more conservative in lending?
Well the argument is that things would be much worse if we didn’t have FHA loans because there would be no liquidity in the market. And although things seem to be bad now time will heel the economy and when the economy has recovered, the propensity for borrowers to default on these loans will fall and therefore make them less risky and more profitable.
I wholeheartedly hope this is the actual case and I am just being a pessimist. However, having experienced the subprime mortgage crisis first hand makes me concerned about less than grade A loans.