The cost of doing business with the Federal Housing Administration could skyrocket if the agency adopts a new method for calculating lenders' liability for poorly underwritten loans that default.
The method under consideration would have the FHA examine a random sampling of each lender's loans, calculate the percentage of loans in the sample with underwriting defects, and then extrapolate that rate to the lender's FHA portfolio. Lenders would then have to compensate FHA for the "estimated total risk" to the agency's insurance fund.
Currently, the FHA, part of the Department of Housing and Urban Development, makes lenders eat the losses on specific loans when defects are discovered. The proposed method would remove the benefit of the doubt for lenders and bring FHA's policies closer to those of the government-sponsored enterprises, Fannie Mae and Freddie Mac
"If this goes through, it means it will be a lot more expensive to be an FHA lender," says Phillip Schulman, a partner at the law firm of K&L Gates. "If a lender runs the risk that every time he makes a mistake it will be multiplied against his entire portfolio, he has to be very cautious."
Schulman, a former assistant general counsel in the inspector general's office at HUD, calls the proposal "draconian" since it appears to adopt a theory of liability that the Justice Department has applied against the largest banks in FHA-related cases. HUD, which oversees the FHA, would now use the same enforcement techniques against every FHA lender, Schulman says.
In June, FHA provided a breakdown of 6,251 loans it reviewed in the first quarter and found that just 19% of loans were deemed acceptable, meaning they had no mistakes. But 44% were "unacceptable," with material loan defects, while another 37% were considered "deficient," with errors that could potentially be corrected.
Overall, roughly 20% of all loans reviewed in the first quarter had some form of documentation error, FHA said in its "Lender Insight" newsletter.
HUD already provides extensive data on lender volumes and performance through its Neighborhood Watch website, which is open to the public.
A key measure for lenders is HUD's compare ratio, or the percentage of mortgages underwritten by a particular lender that were seriously delinquent (that is, more than 90 days past due) or that produced a claim as a proportion of the rate for all lenders in a particular area.
A compare ratio of 100 means that a lender's performance is on par with the default rate for all originators; a compare ratio above 100 indicates poor performance, and perhaps underwriting problems.
But compare ratios can be deceptive, skewed by factors like the "denominator effect," where increases in originations can suppress delinquency rates, and, conversely, declines in originations t can exaggerate delinquency rates.
So FHA has proposed adding other measurements to determine if lenders are engaging in prudent lending standards, not just how they stack up against peers.
"Now it's no longer just comparing you to other lenders," says Melissa Klimkiewicz, an attorney at BuckleySandler. "You may be the very best lender out there but if you still have mistakes, you'll be subject to more scrutiny."
In addition, FHA may set a maximum threshold for the percent of loans with defects, that when surpassed would automatically trigger additional oversight or an enforcement action.
"They are coming up with new standards to measure lenders by that could trigger audits," says Alice Alvey, a senior vice president at Indecomm Mortgage U, a training and consulting firm.