One of the less-examined cracks in the foundations of the Federal Housing Administration is the lending done in recent years by home builders' financing arms.

The default rates on recent loans originated by the mortgage units of Centex Corp., Lennar Corp., and D.R. Horton Inc. run from 129% to 160% of the national average for FHA, which is part of the Department of Housing and Urban Development. While that's better than the 200%-plus ratios of the 15 lenders that HUD's inspector general subpoenaed last month, all three builders' mortgage shops rank among the 10 worst-performing lenders of the 50 highest-volume FHA originators.

Part of the problem, observers believe, is that being an in-house lender at a company whose main business is selling houses makes for loose underwriting.

"Owner financing just creates a conflict," said David Lykken, the president of the Austin consulting firm Mortgage Banking Solutions.

Lykken said he has consulted for some builder in-house mortgage shops and found some to be run responsibly. But in an era when lending standards were declining across the board, he said, many of the publicly traded builders started lowering their standards to match.

"They were saying, 'Well, why is it I own a mortgage company if I have to send buyers across town to another company to get deals done?'"

Brian Sullivan, a spokesman for HUD, said the FHA reviews lender performance on a case-by-case basis, without regard to affiliation or business model.

But the agency has the right to demand lenders indemnify it for losses on poorly underwritten loans, he said, and "if their loan performance is impacted by virtue of their affiliations, that could become an issue."

Affiliations are not the only factor, however.

Some observers pointed to the builders' heavy presence in markets that became overheated. The builders themselves argue that statistical quirks explain much of their underperformance. And everyone interviewed for this story agreed that seller-funded down-payment assistance programs, which Congress banned in October 2008, likely played a role in the builders' high default rates.

"HUD is grappling with, how do you differentiate between lenders whose high default rate is because of factors beyond their control and lenders who have direct responsibility?" said Brian Chappelle, a former FHA official who now runs the Washington consulting firm Potomac Partners.

"I know the builders are worried. They think their situation is unique, because historically new construction has performed very well."

Last month, HUD said that every three months it will review all FHA loans originated over the preceding two years.

For the first review, covering loans made through Dec. 31 of last year, HUD said, it could terminate any lender whose default and claim rate was more than triple that of its region and higher than the national rate.

Two builder-affiliated lenders already meet that criteria, and would be in danger of getting booted — were it not for the fact that they have already shut down.

In Las Vegas, Centex's CTX Mortgage ran a 27% default rate in the two-year period, more than triple that of its peers. And in Los Angeles, loans by D.R. Horton's DHI Mortgage Co. have produced a 19% default rate, yielding an off-the-charts compare ratio of 572%.

DHI stopped originating loans last year. The company didn't respond to requests for comment.

Pulte Homes Inc. of Bloomfield Hills, Mich.. bought Centex last year; CTX Mortgage ceased writing loans on Dec. 31. Jim Zeumer, a Pulte spokesman, said the company would "honor its financial obligations" were the FHA to seek indemnification. (Pulte's own in-house lender has a better record than Centex's, but only slightly more than half the volume, according to HUD data.)

In Santa Ana, Calif., Lennar's Universal American Mortgage Co. produced an 11% default rate for the two-year period that ended Dec. 31, 2009, or 238% of the local average. Though high, that is not bad enough to get the lender kicked out in the FHA's first three-month review.

Marshall Ames, a Lennar vice president, said that while the company would like Universal American to perform at or above the FHA average, "we do not believe that we are significantly outside the range of other builders, and we are certainly not among the worst FHA defaults of any company."

Over time it will get tougher for any lender to stay on the FHA roster. Beginning with the review of loans originated through Dec. 31 of this year, a default rate more than double the regional rate and higher than the national one will get a lender booted, HUD said last month.

Chris Mayer, a professor and director of research at Columbia University's Paul Milstein Center for Real Estate, said builders might have been inclined to provide incentives, such as subsidized closing costs, that other home sellers wouldn't.

When it came to marginal borrowers, he said, "you would be awfully worried that the [builders'] lenders have an additional profit incentive to make the loans."

David Ledford, a senior staff vice president at the National Association of Homebuilders, argued that the builders have a reputational incentive to avoid writing bad FHA loans. At least some of the gap in performance, Ledford said, may be because home-purchase loans often perform worse than refinancings, something that HUD's Neighborhood Watch database doesn't account for.

Lykken, Mayer and Chappelle pointed to seller-funded down payment assistance as a major explanation for the poor performance of builder-affiliated originators. The now-defunct program effectively allowed lenders to issue FHA-insured no-money-down loans, a process the agency now blames for a default rate triple that of the rest of the portfolio.

D.R. Horton's most recent quarterly report notes that, in the final year before such loans were banned, FHA seller-funded down payment loans accounted for a full quarter of its total sales. According to HUD data, CTX, DHI and Universal American were all among the top partners of the Nehemiah Corp. of America, the single largest arranger of down-payment assistance. Together, the three partnered with Nehemiah on the sale of $3.5 billion in homes.

Ledford, whose trade group favored preserving the program in some form, said its demise "means you can certainly remove that as a factor going forward."

The likelihood that some of the builders' problems stem from down payment assistance, along with geographic factors, could help builders mount a defense of their lending with FHA, Chappelle said. "No one has a problem with them going after lenders where the lenders are at fault. But it can be a lot more complicated than defaults and claims."

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