Should We “Fix” FHA Financing?

With all the screaming and shouting about subprime loans it’s sometimes forgotten that there’s a lending category which actually has a worse delinquency rate. According to the Mortgage Bankers Association, in the fourth quarter of 2006 the delinquency rate for subprime loans was 13.33 percent while the rate for mortgages insured by the Federal Housing Administration (FHA) was 13.46 percent.


Although subprime loans still lead the league in foreclosures at 4.53 percent versus 2.19 percent for FHA financing, it’s the FHA program that’s the subject of growing “reform” efforts.


Why change the FHA program? While the mortgage marketplace grew rapidly during the past few years, the FHA program shrank. In 2003, for example, 1.4 million FHA loans worth $366 billion were originated. By 2006 FHA production slid to 523,000 new loans worth just $58 billion according to the Mortgage Insurance Companies of America (MICA).


Since 1934, the FHA has played an important role in the mortgage marketplace. As John M. Robbins, chairman of the Mortgage Bankers Association, said recently in congressional testimony, the “FHA has a strong history of innovating mortgage products to serve an increasing number of homebuyers. FHA was the first nationwide mortgage program; the first to offer 20-year, 25-year and finally 30-year amortizing mortgages; and the first to lower down payment requirements from 20 percent to ten percent to five percent to three percent. FHA has always performed a market stabilizing function by ensuring that mortgage lending continued after local economic collapses or regional natural disasters when many other lenders and mortgage insurers pulled out of these markets.”


Now, says Robbins, his group wants to update FHA so it can “continue to be a financially sound tool for lenders to use in serving the housing needs of American families who are un-served or underserved by conventional markets.”


Calls for FHA “reform” are based on two concerns. First, FHA loan volume is declining. Second, despite high foreclosure levels, the FHA program is self-funded and has never relied on taxpayer subsidies. However, MBA says that under the budget proposal for fiscal 2008 FHA insurance costs will have to be raised to avoid a shortfall.


How much will the mortgage insurance premium (MIP) increase? According to the MBA, the up front fee will increase from 1.5 percent to 1.66 percent while the monthly premium will go from .50 percent to .55 percent. For an FHA borrower with a $200,000 loan, the increases will cost an additional $320 at closing plus an extra $100 per year.


To head off expected premium increases, the FHA should have, as Robbins told Congress, “greater autonomy to make changes to their programs and to develop new products that will better serve those who are not being adequately served by others in the mortgage market.”


But what does “greater autonomy to make changes” really mean? For instance:


Under FHA rules borrowers must submit full-document loan applications. Would it be better to use the “stated-income” loan applications and unverified data now so popular among private lenders? Aren’t these so-called “liar’s loans” the very type of application most likely to be inaccurate if not fraudulent?


The FHA requires that borrowers verify a two-year employment history. How would the FHA program be improved if employment claims went unchecked.



The FHA requires a physical appraisal of the property. Do not such appraisals protect borrowers from over-paying and lenders from over-lending by assuring that the property has a realistic fair market value? How would private-sector valuations such as automated appraisals, drive-by appraisals or broker’s price opinions (BPO) offer more protection for borrowers?


The FHA typically has liberal underwriting standards, generally 29/44. That is, as much as 29 percent of an individual’s gross monthly income can be used for housing expenses such as mortgage principal, interest, taxes and insurance (PITI). As much as 44 percent of gross monthly income can be used for PITI plus regular credit costs such as auto payments and student loans. In comparison, a fixed-rate loan likely has qualifying ratios of 28/36 while an ARM borrower might qualify on the basis of a 33/38 ratio. The VA program has ratios of 41/41. The higher the ratio the more an individual can qualify to borrow.


Given that FHA qualifying ratios are already among the most liberal, does it make sense to make them even more liberal — and thus more risky? Or should FHA ratios be made more conservative, thereby reducing the number of potential borrowers who could qualify for given levels of financing?


The FHA typically requires 3 percent down when making a loan. This is in stark contrast to the 100-percent financing offered by many lenders as well as loans which allow even more than 100-percent financing. Would it be prudent to originate loans with less down within a program which already has sky-high delinquency and foreclosure levels?


The size of FHA loans is limited to 87 percent of the conventional mortgage limit. That is, in 2007 the conventional loan limit is $417,000 for a single-family house but only $362,790 under the FHA program — and even this limit is not available in all communities. Since the FHA insures 100 percent of all loans it backs (as opposed to 25 percent for private mortgage insurance or “MI”), why would it make sense to increase the size of FHA loans and thus the potential debt the program could incur with each foreclosure?


Are higher insurance fees a serious issue? Is it unreasonable to expect someone with a $200,000 mortgage to be able to pay an additional $8.50 a month ($100 divided by 12 months)? If someone cannot afford an additional $320 at closing then is it believable that they can make payments on a $200,000 mortgage?


The truth is that the lending community has already used its Washington power to change the FHA program. The change — and the result — are telling.


In 2001, the FHA received congressional authority to offer adjustable-rate mortgages. Unlike conventional adjustable-rate mortgages, however, the FHA program limited interest rate increases. For instance, it limited the initial and annual interest rate increase to 1 percent for 3/1 and 5/1 ARMs. The lifetime cap was limited to 5 percent.


The “problem” with these caps is that they were far more attractive than the terms offered with private-sector ARMs. Those loans typically allowed a 2 percent initial and annual rate increase, not 1 percent. As to the lifetime cap, it was generally 6 percent above the initial rate, not the 5-percent cap offered under the FHA program.

What to do about this matter?


“At MBA’s urging,” says the Association, “a technical fix to the authorizing language was made with the signing of Public Law 108-186 on December 16, 2003. This law provides an initial rate adjustment cap of 2 percent and a lifetime cap of 6 percent for any loans with an initial fixed rate period longer than 3 years, thereby making the 5/1 hybrid ARM product viable.”

For various reasons the cap changes did not become effective until April 2005.


Under the technical fix borrowers could see rates rise as much as 2 percent per year instead of 1 percent. Is a 1 percent difference a big deal? Sure. If you have a $200,000 FHA it means the maximum interest increase could be $3,000 a year instead of $1,500. That’s an additional cost of $125 a month. If you’re a lender with $10 billion in FHA loans it means your income could increase an additional $100 million a year. No less important, if you’re a lender you have no reason to offer competing ARMs with a 1 percent annual cap or a 5 percent lifetime cap.


Ask yourself: Who benefits from higher caps? Borrowers? Or lenders? What’s more likely to cause delinquencies and foreclosures, low caps or high caps? If the “technical” changes pushed by the private sector are so good, how come FHA originations sank while conventional originations soared? If higher loan costs are a good idea, which consumer groups supported more expensive financing?


“The importance of the FHA program is not the number of loans it originates each year but the fact that private lenders must compete with FHA offerings,” says James J. Saccacio, chief executive officer of, the leading online marketplace for foreclosure properties. “The FHA is a governmental agency so the measures of its ‘success’ or ‘failure’ should be different than the standards we use for a private business. The goal of any FHA reform effort should be to assure that the system remains viable, self-supporting and continues its historic role as a reliable source of low-cost mortgage alternatives.”


Peter G. Miller is the author of The Common-Sense Mortgage and is a syndicated columnist in more than 110 newspapers.






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