DEC 26, 2013

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What We're Hearing

Face It: FHA’s the Only Game in Town for Subprime Borrowers

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There is a lot of misinformation in the mortgage market these days about the Federal Housing Administration's role, particularly its mission of making credit available to middle- and low-income borrowers.

In a recent New York Times article, Edward Pinto, a resident fellow of the American Enterprise Institute, called FHA loans "predatory" and "abusive," and said the strongest FHA borrowers "might be better off going through the private sector." At the same time, Pinto, who has long been an advocate of private mortgage insurance, argued that most FHA loans are at high risk for default if there's another recession.

In the same article, David Stevens, president of the Mortgage Bankers Association, debunked most of Pinto's argument. But perhaps inadvertently, Stevens lent support to one of Pinto's claims—that low-risk borrowers are overpaying for FHA loans—when he said borrowers with a minimum FICO score of 740 who can put at least 5% down are better off with a Fannie Mae-backed loan. The trouble with dwelling on the prime market segment is that such borrowers are relatively well-served; more than four out of five loans backed by Fannie Mae and Freddie Mac have credit scores above 720.

What voices like Pinto fail to recognize, and what that quote from Stevens misses, is that there is no alternative to the FHA for the low-credit-score borrowers. While commercial banks and government-sponsored entities such as Fannie and Freddie cater to high-income, high-FICO score, prime borrowers, the FHA is the only game in town for the rest of the market. Close to half of all FHA loans originated in 2013 were for FICO scores of 620 to 679, about a quarter of the loans were for 680 to 719 and roughly a quarter were for 720 and higher, according to data from the FHA.

Now, Pinto is correct that the FHA should not be in the business of underwriting prime loans, especially that quarter of the production above 720 FICOs. But the anti-FHA crowd's effort to undermine government support for homeownership and push for privatization makes no sense in today's market, especially with loan application and lending volumes falling.

If we all still retain the agenda of the "American dream" of homeownership, FHA is the only current alternative. But in a letter to regulators in October, Pinto, joined by fellow AEI scholars Peter Wallison and Alex Pollock, basically told Americans with FICO scores below 740 that they will always be forced into expensive rental housing and never have the opportunity to own a home:

"To avoid future housing bubbles, we must ensure that prime loans comprise the lion's share of the mortgage market. Thus, the [qualified residential mortgage] must be reworked to incorporate the impact of the four key components of a quality mortgage: demonstrated credit, a significant down payment, the capacity to make payments over the life of the loan, and loan purpose (home purchase, non-cash out from a refinance, and cash out from a refinance)."

Sadly, the experts at AEI and others in Washington fail to appreciate that government regulation has already accomplished the goal of excluding millions of Americans from the mortgage markets. The poisonous combination of Dodd-Frank legislation, the mortgage foreclosure settlement by the state attorneys general and the Basel III capital rules prevents commercial banks from making anything but prime loans. Add to this the end of the safe harbor for "true sales" of asset-backed securities by the Federal Deposit Insurance Corp. in 2010 and you can virtually guarantee that no FDIC-insured commercial bank will underwrite a nonprime, non-QRM loan or securitization ever again.

Despite the rhetoric about the return of private residential mortgage-backed securities, the fact is that there is virtually no private market for below-prime loans in the U.S. today. How many times have we heard acting Federal Housing Finance Agency head Ed DeMarco comment that raising guarantee fees for Fannie and Freddie will stimulate private sector interest in the mortgage market?

Not only have higher fees and loan limits for the FHA and the GSEs failed to spark investor interest in holding private mortgages, but these statements suggest that government officials are either delusional or just plain ignorant with respect to how the capital markets view private label, nonagency loan production today. The market for nonagency RMBS is running off and there is virtually no new production to replace it. For millions of Americans, there is no alternative to the FHA when it comes to getting a mortgage.

Thankfully Stevens, a former FHA Commissioner, pointed out to the Times the agency's recent tightening of underwriting standards and its improved portfolio quality, illustrated by a recent Congressional Budget Office study.

"The data clearly shows that the loans being made today by FHA are the highest-quality loans in its history, with extremely low default rates," Stevens told the paper.

Observers inside and outside the mortgage market need to accept that government regulation, investor reticence and other factors make FHA the only available source of mortgage credit for below-prime borrowers. Before we consign millions of Americans to a life of perpetual tenancy, we need to get observers on all sides of the debate to put aside the rhetoric and focus on market realities.

I hope my friends at AEI like Pinto, Wallison and Pollock will accept that regulation is the chief obstacle here and become part of a conversation about how we make credit available to below-prime borrowers in a prudential and responsible fashion.

Christopher Whalen is executive vice president at Carrington Holding Co., a private, nonbank firm focused on selling, financing and managing residential real estate.

Comments (1)
Absolutely, right on. FHA is the only game for low-credit score borrowers. Unfortunately, the comments about stringent regulations is also true. We estimate that nearly 40% of all Americans will not qualify for a mortgage loan. This will have a disparate impact on minorities. Minorities have lower credit scores on average, which is a proxy for lower income.

Also, there is a potential landmine in the new QM and ATR rules ready to go into effect. Consider a borrower who has a good credit score, say 660, total DTI of 48%, lots of unpaid collections (non-medical) on his credit report but has sufficient income to count 5% of the unpaid collections as part of the monthly obligations, and gets an approval on the FHA Total Scorecard.

Three years down the road he defaults on the mortgage and claims that the loan should never have been made, that he has a history of never paying his obligations and that this is a violation of the QM rules. Some attorney will take the case and the lender is likely to lose. If he never pays why would you make the loan, notwithstanding the FHA approval. Plus with a 48% back ratio it would be problematic for any but a high income borrower.

Boom!

Posted by Frank Previte | Friday, January 03 2014 at 12:59PM ET
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