Sep282015

FHA insures subprime loans with explicit government backing

If the FHA insurance fund falls short, the US taxpayer will pay the difference. With the FHA insuring subprime loans, as a taxpayer, your money is at risk.

Many mortgage industry observers quipped that FHA is the reincarnation of subprime lending; the facts support this assertion. The FHA has very low standards for qualification (a 580 FICO score), a very low down payment requirement (currently 3.5%). Consequently, FHA insured loans became a necessity for anyone without the credit score or down payment to obtain other financing. fha_rescue

Clearly, FHA filled the void created by the collapse of subprime lending.

For the subprime business model to work, lenders much charge higher interest rates and fees to offset the losses on the numerous loans certain to go bad. I reported in 2013 that the FHA increased their fees so high they became a predatory lender. By 2014 the high cost of FHA loans caused originations to plunge, so I predicted that pressure would mount to lower FHA fees. Not long thereafter, the FHA did lower its fees, and it’s one of the main reasons sales are higher this year.

The fact remains that FHA loans are the new subprime, and Kevin Watters, CEO of Chase Mortgage Banking had the courage to say so.

Did Chase Mortgage CEO get it wrong to call FHA lending subprime?.

Edward J. Pinto, September 25, 2015

Recently Kevin Watters, CEO of Chase Mortgage Banking, compared low FICO, low down payment FHA loans to subprime.  While he conflated a couple of FHA’s underwriting criteria, the fact remains that FHA’s core 30-year loan program allows borrowers with a down payment of 3.5% to have a FICO score as low as 580, along with a total debt-to-income ratio of 50% or more.

I find it increasingly annoying when real estate industry shills conclude every statement with the repetitious lie that lending standards are too tight. Mortgage lending standards are not tight, and the bullshit needs to stop.

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These loans are subprime based on risk, having an AEI mortgage default risk score under stress of 40%.

These are subprime loans based on history: the indicia of subprime have long been impaired credit as represented by a FICO score of less than 660 or a total debt ratio of greater than 42%.

Finally, FHA loans are subprime based on marketing. One of FHA’s major lenders, Carrington Mortgage, ran an advertisement stating – (emphasis added) – “We have loan programs specifically tailored to credit-challenged borrowers so there is no need to turn away those borrowers with low FICO scores.”

Today, one third of FHA’s borrowers has a FICO score less than 660,

Let that sink in: 1/3 of FHA borrowers have FICO scores under 660. Remember, as a taxpayer, you are on the hook if these people quit paying and the FHA insurance fund doesn’t have the money to cover the losses.

with Carrington having the lowest median FICO score — at 620— of any of FHA’s major lenders.  Today, nearly half of FHA’s borrowers have a total debt ratio of greater than 42%.

Do you remember the 43% debt-to-income ratio cap created by Dodd-Frank? Well, FHA is exempt from that requirement, and they now provide oversized loans to over half their customers. This is a government agency “helping” people drown in debt.

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Kevin Watters was right;  much of FHA’s lending is subprime.

Will subprime mortgage lending 2.0 be a disaster? Let’s hope not.

Our current housing finance system is a mess. It’s laden with moral hazard, and likely to implode with enormous losses to be absorbed at taxpayer expense. All our current policies are geared toward saving our banking system from financial ruin and making loan owners comfortable with their fate. As with any policy initiatives that distort the natural market, the current system is loaded with unintended incentives that permit people to game the system for their personal advantage.

FHA loans as a stoploss

Back in 2006 when I started publicly warning people not to buy homes due to the impending crash, I pointed out to people that there is no stoploss protection in event of a major decline in prices. Leverage works both ways, and the people who were making huge money on small investments were enjoying stellar returns. However, if prices go the other way, the losses are even more brutal.

Another commonly leveraged investment is stocks. People in a margin account can buy twice as much stock as they can afford by borrowing money from their broker. In the event stock prices collapse, the broker will close out an investor’s position before the account goes negative to preserve their original loan capital. There is no such stoploss protection in residential real estate. If house prices go down, people lose money until prices stop going down. They can easily lose many times their original down payment investment.

Well, at least that used to be true…

Now in an era of short sales as an entitlement, borrowers and speculators have no downside risk beyond their initial down payment. If values go down, people simply petition for a short sale, and the lender absorbs the loss. And when that loan is an FHA loan, the lender simply passes the loss on to the US taxpayer.

The incentive here is clear. Everyone should put the minimum possible down payment on a property to minimize their own exposure. If prices go down, they can petition for a loan modification, a short sale, or simply strategically default with no financial repercussions.

This system needs to be changed

The above is the best advice I can give a buyer in today’s market — and that pains me. It’s terrible that our system encourages both bankers and buyers to pass their losses on to the US taxpayer. As one of them, it’s infuriating to see how our government’s policies to coddle the banks has created a system where both bankers and borrowers can pass their bad bets on to all of us.

Unfortunately, that’s the reality of life.

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