With delinquencies rising on Federal Housing Administration-insured loans, banks are expected to repurchase billions of dollars of such loans this year from the Government National Mortgage Association.
These purchases require huge up-front outlays, but taking the delinquent loans back on to their balance sheets enables banks to stop making regular principal and interest payments to bond investors.
While this can cause some short-term pain, analysts say it's a better long-term strategy than making regular payments to cover delinquent borrowers. And, since the loans are insured by the FHA, the banks will eventually be reimbursed for any losses.
"We saw very high volumes of buyouts in the second half of 2009, and we would expect that to continue into 2010 given the high delinquency rates of FHA loans," said Robert Fishman, Ginnie Mae's chief risk officer.
Qumber Hassan, a mortgage strategist at Credit Suisse, said delinquencies on the securities that Ginnie has packaged from FHA loans could double or even triple by yearend, to between 7.4% and 12%, though not all the loans will require that the FHA pay claims and most have not even begun the process of loss mitigation.
"If delinquencies reach as high as 10%," banks "will potentially need to buy out $50 billion of loans," Hassan said.
Once an FHA loan has been delinquent for 90 days, the bank that issued it can buy it back from the Ginnie bond pool, and stop advancing principal and interest to the bondholders. Even if borrowers are no longer making monthly payments, the banks are required to continue doing so.
In an interview Friday, FHA Commissioner David Stevens said that while he expects a much higher claim rate this year, "the numbers coming in are lower than what we forecast" in an audit report the FHA released in October. The actuarial report had forecast 135,000 claims for fiscal 2010, which ends on Oct. 31 of this year, and Stevens said "we're well behind that pace."
Roughly 75% of Ginnie pools are backed by FHA loans. Delinquent loans that were repurchased by banks last year "are absolutely folded into the FHA's insurance fund calculations," Fishman said.
Repurchasing delinquent FHA loans is expensive, and results in a massive increase in delinquent loans on banks' balance sheets.
For example, Bank of America Corp. repurchased $9.4 billion of delinquent government-insured loans from Ginnie securitizations in the fourth quarter alone, up from $1.8 billion of repurchases in the third quarter.
This caused B of A's total nonperforming loans to zoom to $62 billion in the fourth quarter, from $49.5 billion in the third quarter.
Wells Fargo & Co. held $15.3 billion of delinquent FHA loans at yearend, up from $8.2 billion in 2008.
Banks are not obligated to repurchase these loans, but Fishman said doing so is cheaper than continuing to advance principal and interest to investors.
Also, issuers with higher delinquency rates can be subject to greater scrutiny, Fishman said; most will opt to buy back the debt to avoid this kind of attention.
"If it's above 5%, … we have a talk" with the issuer, he said.
The agency has urged issuers to keep delinquency rates below 5%, and buying back delinquent loans can help them reach that level. The current delinquency rate of FHA loans is 9.1% while Ginnie's delinquent rate is 2.35%, he said.
Stevens also wants to have more authority to force banks to buy back bad loans. He is asking Congress to give the agency more power to require indemnification for loans that were improperly originated or where fraud or misrepresentations occurred.
Last week, Stevens testified at a House Financial Services subcommittee hearing that the FHA currently has the authority to indemnify just 29% of lenders for losses on loans that involved underwriting errors or fraud.
"We have to close that loophole," he said Friday. "This stands out as a glaring gap."
(FHA currently has $31 billion to cover losses over the next 30 years and is taking steps to minimize losses to its capital reserves.)
"What we are seeing across time is the government guarantee is skyrocketing in terms of underperforming loans," said Bill Moreland, president of PeerMetrics Inc., a Dallas consulting firm.
Most of the banks that repurchase delinquent loans will try to work with the borrower by offering a loan modification or even a principal writedown with the intent of getting the borrower back into a new FHA loan that can be resecuritized.
A growing concern is that loans originated last year are performing just as badly as those from 2007 despite higher credit scores, lower fraud and the 2008 elimination of the FHA's down-payment assistance program, he said.
Hassan attributed the weak performance to a drop in housing prices and high unemployment.
"We anticipate that 2009 vintage delinquencies could reach 11% by yearend if they continue along their current trajectory," he said.
Frank Pallotta, an executive vice president and managing partner of Loan Value Group Inc., a privately held advisory firm, gave another explanation for the weak performance of vintage 2009 loans.
Many banks are working with delinquent borrowers by offering loan modifications including principal writedowns on nonagency private-label loans held by banks. Once those loans start performing, the banks would rather move them to the FHA.
"A lot of banks and Wall Street firms have found another chink in the armor. They tweak a loan, collect new origination fees and put the borrower back into an FHA loan, so the risk is right back on the taxpayer," said Pallotta.
"There should be higher hurdles depending on the risk profile" of the borrower and the loan.