The Wall Street Journal
By: AnnaMaria Andriotis
August 9, 2010
Is this the end of the cheap Federal Housing Administration mortgage?
Over the last few years, as the private mortgage market has remained in lockdown, the FHA, which is backed by the government, has increased its lending activity. Instead of requiring borrowers to put down 20% on a home as a bank might, FHA mortgages require as little as 3.5% down.
The low barrier to entry made FHA mortgages a more popular option among borrowers. Today, they make up about 30% of the existing mortgage marketplace, up from just 3% in 2006, according to the CMPS Institute, which trains and certifies mortgage lenders and brokers.
Now, some of the friendly terms attached to FHA mortgages are about to change, thanks to the rising risks and losses associated with these loans. Ninety-day delinquencies, bankruptcies and foreclosures have been rising during the past year, according to the Department of Housing and Urban Development's quarterly report to Congress this month. During its third quarter, 21.1% of FHA mortgages that were underwritten in 2007 and 17.3% that were underwritten in 2008 fell into this category, up from 14.2% and 8.4%, respectively, a year ago. And of the mortgages that were underwritten in 2009, 4.9% fell into this category during the last quarter.
The FHA's reserve funds, which the administration uses to cover losses from these mortgages when borrowers default or go into foreclosure, are shrinking. As of June 30, its capital reserve account had dwindled to $3.5 billion, compared to a $19.3 billion balance on Sept. 30, 2008, according to the HUD report. The FHA's financing account, which takes money from the reserve account to pay for these losses, has been increasing and currently stands at $29.6 billion, up from $9 billion on Sept. 30, 2008.
"It's a valid concern that [the accounts] could be depleted, [and] if house prices are expected to decline in a meaningful way that would have a negative impact on the capital reserves," says Bob Ryan, chief risk officer at the FHA.
To reduce future risk, the FHA is raising borrower requirements and increasing the costs attached to these mortgages. Here are four changes that potential FHA-mortgage borrowers can expect.
Higher annual insurance premiums
On Wednesday, the Senate passed a bill that gives the FHA flexibility to increase the annual insurance premiums on its mortgages. After President Obama signs the bill into law, the FHA expects to enact the change by the end of the year, Ryan says.
The agency plans to raise the annual premium from a range of 0.50% to 0.55% to a range of 0.85% to 0.90%, he says. The annual premium is paid along with the monthly payment, but it is not rolled into the mortgage. In exchange, the FHA will likely lower the required upfront premium from 2.25% to 1.00%. (The upfront premium can be rolled into the mortgage.) Both fees pay for the FHA insurance that makes the loan possible.
These changes will result in a "net increase in the mortgage insurance premium, which means we have more resources available in the event that losses that do occur, [and] it provides us greater protection in the event that house prices should fall," Ryan says.
The changes could help borrowers who were previously unable to afford an FHA mortgage because of the upfront premium, says Keith Gumbinger, a vice president at HSH Associates, a mortgage-data tracking firm. The result could be a more affordable mortgage for borrowers, which ultimately provides more ongoing capital to FHA over the life of the loan, he says.
Reduce seller contributions to closing costs
Earlier this year, the FHA proposed new changes that would raise the requirements to get approved for an FHA mortgage. The FHA has permitted a public comment period on its proposals, which comes to an end on Aug. 16. Then it will begin finalizing its proposals. Ryan declined to comment on how soon the changes would go into effect.
Among the changes is a reduction in how much sellers can contribute toward the closing costs. Until now, sellers have been able to pay for up to 6% of closing costs toward the buyer's purchase of their home. According to the new proposals, sellers would be limited to contributing up to 3%.
New credit score requirements
The proposals also include changes to credit score requirements.
Historically, the FHA hasn't had an official minimum required credit score, leaving that decision mostly up to the lenders underwriting FHA mortgages. Now, the agency is proposing a minimum required credit score of 500 to get approved for an FHA mortgage and a minimum credit score of 580 in order to qualify for the 3.5% down payment. Borrowers with a credit score between 500 and 580 will have to make a down payment of at least 10%. (The score requirement is low compared to that of a conventional mortgage, which demands a score of at least 660 to 720 to qualify for a loan with a 10% down payment, says Gibran Nicholas, the chairman of the CMPS Institute).
The FHA is also requesting that lenders tighten underwriting standards by looking more closely at a borrower's credit history, debt-to-income ratio and cash reserves.
These changes would reduce risk for the FHA by setting a minimum threshold for banks and reducing the chances of lending to a borrower with a low credit score, Nicholas says. FHA-approved lenders are comfortable providing these mortgages because they're backed by the government, and that means the lenders won't incur the loss if a borrower defaults on their mortgage. Instead, the FHA pays the lender an insurance claim equal to the sum of the unpaid principal balance of the loan, foregone interest and a portion of the foreclosure expenses. But it seems that most lenders minimum required credit scores are already higher. As of April 2010, just 2.4% of FHA mortgages issued by approved lenders went to borrowers with a credit score less than 620, says Herb Blecher, vice president of LPS Applied Analytics, which tracks mortgage performance. That's down from 37.5% from January 2008, he says.
Recent changes already in effect
These proposals are the latest in a series of changes that have impacted FHA mortgages. In November 2009, the FHA hired its first chief risk officer in its 75-year history, and last month the agency established a risk management office to oversee operational risk. In April, the FHA increased the upfront insurance premium from 1.75% to 2.25% of the mortgage balance. And in 2008, it increased its minimum down payment from 3.0% to 3.5%.
"You can get the sense that the FHA has been struggling with losses, and they didn't necessarily want to go to Congress to ask for money, so instead they're getting their fiscal house in order first," says Gumbinger.
However, he adds, their requirements are still comparatively liberal. "They are becoming the de facto subprime in the market and that isn't necessarily good from a taxpayer stand point," he says. Although full documentation of employment is required before a borrower gets approved for an FHA mortgage, the biggest risk remains the low down payment, especially at a time when home values in many parts of the country are still dropping. Those declines could leave many new borrowers underwater within a few months of their home purchase.