It has been two years since the private-label mortgage market collapsed and the Federal Housing Administration's resurgence started. Almost immediately, some members of Congress, the press and even mortgage industry executives were concerned that the FHA would become the new subprime "dumping ground" exposing the American taxpayer to billions of dollars of losses.
Now two years later, the latest round of data and analysis by its outside auditor show that the FHA is financially sound and unlikely to need any government assistance (barring an unexpected economic downturn that would adversely affect the performance of all mortgages).
The FHA relies on two principles that have become cornerstones of the Obama administration's mortgage reform plan — "skin in the game" and "plain vanilla." Before discussing how these concepts are applied in the FHA program, here is a quick review of the latest data points.
- The FHA's capital ratio is projected to remain above the congressionally mandated 2% level.
- Its fiscal year 2010 book of business is expected to "earn a profit" of $1.7 billion.
- It recently announced that it will not be necessary to raise mortgage insurance premiums for FY 2010.
- Its most serious underwriting deficiencies have been addressed, including the elimination of the seller-funded down payment program. This change reduces the FHA's costs by $2.5 billion in FY 2010.
- FHA loans are performing better on a relative basis than prime loans. According to the latest federal regulator report on bank portfolio performance, the share of prime loans that are seriously delinquent has increased 161%, while the FHA rate has increased only 30%.
- The agency's borrower credit profile has improved dramatically, with average borrower FICO scores increasing from 626 to 692 in the last year.
Probably even more important, the percentage of FHA homebuyers with higher risk characteristics (FICO scores below 620) has declined precipitously in the last two years (from 45% in June 2007 to 7% in June 2009). Dispelling the myth that the FHA is being flooded with subprime loans, the agency insured 43% fewer purchase loans with FICO scores below 620 in June 2009 than were insured in June 2007, even though its purchase activity increased 345%.
How has the FHA managed to remain sound when other larger institutions have experienced massive losses?
FHA lenders have strong financial incentives (skin in the game) to adhere to prudent underwriting standards and, in contrast to the conventional market, the FHA never wavered from requiring fully documented (plain vanilla), amortizing loans (primarily 30-year, fixed-rate) in accordance with established underwriting standards. For example, the significant decrease in the number of borrowers with low FICO scores is the result of FHA lenders imposing minimum FICO scores to mitigate risk.
Unlike alternative-A and subprime loans, FHA loans are priced correctly in the secondary market, since the ultimate value of an FHA loan is the income derived from servicing a performing loan. Because FHA lenders lose approximately 2%-3% of the loan amount in the event of a foreclosure, large purchasers/servicers have a financial incentive to make sure FHA loans perform well and they also hold originators accountable through buybacks in case of early defaults. In short, performance matters.
As the FHA's recent action with respect to Taylor, Bean & Whitaker Mortgage Corp. demonstrates, participating lenders also have audit risk. The FHA recertifies all lenders annually and requires immediate notification of any material changes in a lender's net worth or any other regulatory violations/settlements. The FHA also focuses its lender monitoring reviews on loans that default shortly after closing and requires indemnification from originating lenders for underwriting deficiencies.
Finally, FHA lenders have reputation risk in the FHA program. For most lenders, the potential damage to a lender's reputation from the public disclosure of any violation of FHA rules in the Federal Register or a Department of Housing and Urban Development press release is a more serious deterrent than virtually any fine or sanction.
It is also expected that the FHA will be tightening underwriting standards soon. David Stevens, the new FHA commissioner, has made "a thorough review of the credit parameters of the FHA program" a top priority.
As the data shows, the FHA has certainly performed better than many expected. It may also surprise many that two "new" concepts — skin in the game and plain vanilla — have been integral parts of the FHA risk management strategy for many years.