The Real Case for FHA Reform

Should you be in favor of FHA modernization? After all, is not modernization always a step forward, something that’s necessary and needed?

“FHA, despite all its success, does need to adapt to today’s marketplace,” says FHA Commissioner Brian Montgomery. “We strongly support legislation that would modernize FHA and enable it to offer many Americans a variety of homeownership options that are safe and fairly priced.”

House Bill 1852, the “Expanding American Homeownership Act” would “enable FHA to be an option for more underserved low- and moderate-income families so they can achieve the American Dream of homeownership,” according to HUD. “Once enacted, the reform legislation would create a new risk-based insurance premium structure, eliminate the current 3 percent minimum down payment, and increase FHA’s loan limits.”

Unfortunately, says the General Accountability Office, FHA reform would also produce other results.

Take the matter of risk-based insurance premiums. Right now, every FHA borrower faces the same insurance cost: 1.5 percent of the loan amount at closing plus an annualized cost of 0.5 percent of the outstanding loan balance each month. In effect, the FHA insurance program moderates risk by including all borrowers, just like a mammoth health insurance pool.

However, under the new system — if it passes — every borrower will pay a mortgage insurance fee based on their credit risk. This too is like health insurance, where smokers pay more for coverage than nonsmokers.

The catch is that, also like the health insurance system, not all applicants will be welcome. Compared with 2005, the GAO estimates that under the new plan 43 percent of all FHA borrowers will face the same or reduced insurance costs, 37 percent will pay more, and 20 percent (those with the highest expected claim rates) will not qualify at all for FHA financing. In effect, a majority of current borrowers will either face higher insurance premiums or will not be able to get an FHA loan and therefore perhaps any mortgage.

Under the new risk-based system, however, the FHA could expect to have better economics — by the GAO’s estimate a $342 million annual surplus rather than a $142 million deficit without modernization.

But if 20 percent of applicants who qualified under the old standard won’t be able to get an FHA loan, will not the number of FHA borrowers actually fall?

Not so, says the GAO. Origination numbers are likely to rise as much as 10 percent over 2005 because the program will no longer require a 3 percent down payment.

In effect, the idea of FHA modernization represents a trade-off: The program will be better for some borrowers but not for others.

But if we’re going to modernize the FHA, are there any other steps we might take that would both reduce risk to the system while bringing in additional borrowers?
For instance, the fastest and easiest way to reduce FHA foreclosures and thus claims against the insurance pool would be to lower borrower costs, something that could be accomplished by returning to earlier standards.

When the FHA first began offering adjustable-rate mortgage products in the 1980s it had some of the most attractive ARMs then available. Why? Because most ARMs then and now allow rates to increase by as much as 2 percent a year, but the FHA program limited annual increases to 1 percent. In addition, while most ARMs have a 6 percent lifetime interest cap above the original start rate, the FHA lifetime cap was set at 5 percentage points.

In other words, if you got an FHA ARM the potential for higher costs was spread over a longer period, plus you would never pay as much as a private-sector ARM borrower.
All of this changed a few years ago.

“At MBA’s urging,” says the Mortgage Bankers 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 three years, thereby making the 5/1 hybrid ARM product viable.”

Viable to whom? This “technical fix” increased potential borrower costs (and thus potential foreclosure rates) and it also did something equally important: It eliminated a popular alternative to private-sector ARMs.

Rather than increasing demand for FHA financing, FHA originations fell from 1.5 million in 2003 to 827,000 in 2004.

“There’s a lot to the idea of FHA modernization which should be welcomed,” says Jim Saccacio, Chairman and CEO at, the leading online marketplace for foreclosure properties. “But if we’re going to change the system to ask more of borrowers, why not also change the system to ask more of lenders? The FHA has traditionally been an alternative to high-cost private-sector loans, not a clone. It’s time to get rid of the program changes which have made the FHA program less attractive to borrowers.”
Columnist Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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