The growing battle between the FHA and the lending industry could soon impact home sales and refinancing nationwide, a contest to win both hearts and minds not to mention loan originations worth billions of dollars.
The basic dispute is this: Lenders sold mortgages to the FHA which allegedly did not meet program standards. HUD, in turn, forced the lenders to buy back the loans. For the banks this has been a very expensive business: one settlement with JPMorgan Chase amounted to $614 million while the Bank of America shelled out an even $1 billion to resolve FHA claims.
It would appear that HUD has won big victories but there’s a problem: No lender is required to make FHA-insured loans anymore then you’re required to buy a particular brand of auto insurance. A lot of lenders believe that the standards requiring FHA buy-backs and settlements are too stringent, claims based on errors so minimal that they have nothing to do with delinquencies or defaults.
In other words, the buy-back rule ought to be no harm, no foul.
Speaking at the National Press Club, Wells Fargo CEO John Stumpf said that in some cases there were buy-back requests for loans which had been steadily paid for ten years. Other “put-backs” were for technicalities. He gave the example of a loan which was for “John G. Stumpf” on the first page and “John Gerard Stumpf” on the second. This, he said, could be an example of a “technical default.”
JPMorgan Chase Chairman and CEO Jamie Dimon said in July that “the real question to me (is) should we be in the FHA business at all and we’re still struggling with that.”
Such comments should be taken seriously. Back in 2009 Dimon said the biggest mistake of his whole career was “not closing down our mortgage broker business sooner.” Much to the distress of mortgage brokers across the country Chase closed its wholesale window to them that year, meaning there was one less huge buyer for their loans.
In a similar sense, Chase, Wells Fargo and the Bank of America can all elect to end the origination of FHA mortgages, an option which gives them considerable marketplace clout. Were that to happen FHA-backed loans would still be available but a big chunk of the program’s business would be gone. Borrowers who wanted FHA loans might have to do more hunting and they might also be forced to pay higher rates.
Indeed, it may be that a general slowing of FHA loans has already begun. As a recent headline from Bloomberg said, “FHA Loans Plunge 19 Percent as Lenders Haggle With Officials.”
Bloomberg, quoting the industry publication, Inside Mortgage Finance, said that FHA originations during the first six months of the year dropped 82 percent at Wells Fargo, 72 percent at Bank of America and 55 percent at JPMorgan Chase.
These numbers seem to suggest that big lenders are running from the FHA program but that’s not the whole story. A big part of the FHA reductions have nothing to do with buy-back disputes, instead they’re related to the overall contraction of the mortgage marketplace.
For instance, the Bank of America reported that in the second quarter first-mortgage originations declined 59 percent. JPMorgan Chase said that in the second quarter mortgage originations were down 66 percent from the prior year while Wells Fargo reported a small production increase.
Meanwhile, FHA loans continue to represent a substantial part of the mortgage marketplace. According to Ellie Mae, FHA-insured loans represented 20 percent of all origination in August, up from 18 percent a year ago, meaning that the FHA market share is stable if not actually growing and that government-backed loans continue to generate considerable demand.
Drawing a Line
Nobody is arguing that FHA loans which substantially miss underwriting standards should be immune from a buy-back demand. The real question is where to draw the line. What, exactly, is a major flaw, a loan representation or warranty so wrong that the lender should be forced to buy back the loan?
Part of the problem is that the underwriting process has become ludicrously complex. With a recent home purchase we were confronted with more than 70 forms and documents at closing. Given so much paperwork the great miracle is that there aren’t more errors.
Mortgage paperwork is not just a lender problem it’s also a consumer issue. Buyers and borrowers as a group have no idea what closing documents say. As former HUD Secretary Mel Martinez told The Washington Post, “you know if I’m a lawyer and the secretary of HUD and I’m not reading this junk, you know there’s work to be done fixing the system.”
Martinez made his remarks in 2001 and if anything the situation has only gotten worse. Indeed, you can think of 2001 as the “good old days,” an innocent time when closings were far more simple and straight forward when compared with today.
Paperwork and Time
“When does credit and when does risk transfer,” asked Wells Fargo CEO Stumpf in his speech to the National Press Club. In other words, why should minor errors which do not impact delinquencies and foreclosures lead to buy-back demands?
One way to assess underwriting quality is to simply look at the results. For instance, imagine that a borrower misses the first payment. That’s not a good sign but is it the lender’s fault? Think of a borrower death or a major auto accident after closing, things which have nothing to do with underwriting quality. In each case it is the obligation of the lender to defend the underwriting process, the central reason why lenders ask for so much documentation.
Minor paperwork defects, which show up after origination, should also be the lender’s problem but rather than force the lender to buy back the loan the more sensible option is simply to fix the documents. Among the many, many forms presented at settlement there’s always one which says the borrowers are obligated to help straighten out paperwork defects found after closing.
Another issue is fraud. A mortgage originated on the basis of fraud, say a material overstatement of income or a deliberate effort to hide debts, should be a problem for the originator for the life of the loan because such misrepresentations were supposed to have been uncovered during the underwriting process. It’s not enough to say “the borrower lied” when it’s the lender’s job to verify the borrowers income, debts, credit and financial status.
A Grace Period
Virtually all mortgages today come with a grace period for borrowers. The payment is due on the first but if the check arrives on or before the 15th there’s no late fee or credit ding. A little flexibility in the system is good for everyone otherwise borrowers and mortgage servicers will be arguing about due dates which fall on national holidays, checks lost in the mail and allegations of slow — and maybe deliberately slow — lender processing.
As it happens a new set of buy-back rules went into effect this summer for loans bought by Fannie Mae and Freddie Mac, rules that could easily work for FHA-backed financing.
First, lender buy-back liabilities end automatically if the loan passes a Fannie Mae/Freddie Mac audit.
Second, under the Fannie Mae/Freddie Mac payment history formula loans are eligible for representation and warranty “relief” according to the following schedule:
- HARP refinances: After 12 months.
- Mortgages without delinquencies: After 36 months of consecutive, on-time payments.
- Mortgages with delinquencies during the first 36 months: Lender warranties can end in five years if the loan is current on the 60th month, provided there are not more than two 30-day delinquencies during the first 36 months.
However, it’s likely that even this new schedule will be revised. The Inspector General for the Federal Housing Finance Agency (FHFA), the regulator which oversees Fannie Mae and Freddie Mac, reported in September that a longer benchmark should be employed because “loans with a 48-month clean payment history were significantly less likely to exhibit re-purchaseable defects than loans with a 36-month clean payment history.”
Will big lenders and the FHA solve their buy-back dispute? The answer is yes because the current war of financial attrition hurts everyone.
The FHA needs the volume represented by big lenders and the lenders need volume to maximize origination systems with large fixed costs. The solution is to straighten-out the system so that ticky-tacky paperwork errors do not lead to buy-backs while substantial and serious underwriting flaws remain the responsibility of the loan originator. The Fannie Mae/Freddie Mac approach provides a likely road to success.