Low down payment loans becoming a thing of the past?

During the housing bubble there were plenty of private mortgage companies underwriting low down payment loans, but they stopped after the bubble burst. Then after the burst low down payment FHA loans grabbed huge share of the mortgage market.  The FHA standards were lowered and conforming limits increased which allowed a greater number of borrowers to put a very low down payment while purchasing a home.  In addition to FHA, Fannie and Freddie conventional loans after the bubble rarely wrote loans under 20%, however this trend has reversed in the past few months.  So, you have three entities writing low down payment loans.  Now, FHA is instituting new requirements on lenders that will probably restrict lending in the future.

FHA Plan Would Make Lenders Eat a Lot More Faulty Loans

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.

The impact of this change means lenders are going to stay away from underwriting FHA loans.  Before the bubble FHA loans were considered difficult and bureaucratic, then they became the only game in town for low down payment loans.  Now, with these proposed rules, I think very few lender will underwrite FHA loans.  Because FHA loans are low down payment there is high chance of default and therefore losses.  If FHA makes lenders more responsible for these losses then what is the profit for lenders if any.  Also, borrowers have decreased usage of FHA loans because their mortgage insurance is over 1%, these higher premiums reflect the risk with low down payments.  It’s estimated that FHA could require a $85 billion dollar bailout, which was the consequence of low down payment lending and not charging enough for mortgage insurance.

Fannie Mae and Freddie Mac and know for their conventional loans with a 20% down payment.  However, they also package and insure lower down payment loans.  Although not many as FHA they have increased the number of loans they guarantee.  However, even Fannie and Freddie are reconsidering underwriting the lowest down payment loans.

Fannie Could Curb Low-Down-Payment Loan Purchases

Fannie Mae is in discussions to curb its purchases of mortgages that require a minimum down-payment of 3%, according to people familiar with the discussions.

Fannie never stopped accepting purchases of loans with 3% down payments, even after lending standards were ratcheted up following the housing bust. But many lenders stopped offering them, in part because they weren’t able to obtain mortgage insurance for those loans, which Fannie requires.

In recent months, however, a series of changes in the mortgage market have led to an uptick in low-down-payment loans available for sale to Fannie. That prompted a review of the company’s lending policies, and officials are said to be working on a plan to limit the company’s purchases of these loans. The changes aren’t being made because of immediate problems with loan performance, according to people familiar with the discussions.

Freddie Macstopped backing such mortgages several years ago and requires a minimum 5% down payment. Any loans without a 20% down payment at both companies must have mortgage insurance or some other type of so-called “credit enhancement.”

One proposal would be to continue purchasing only those sold by housing-finance agencies, which typically require home buyers to complete financial counseling. “We regularly review our standards and guidelines,” said Andrew Wilson, a Fannie Mae spokesman. “Any changes to our guidelines will be communicated to the market at the appropriate time.”

Even though Fannie hasn’t bought many of these loans, low down-payment loans have remained widely available throughout the housing downturn largely due to federal agencies, including the Federal Housing Administration, which insures mortgages with down payments of 3.5%. Veterans and rural homeowners can still obtain loans without any down payment through separate federal agencies, though they face some restrictions.

But Fannie is seeing more low-down-lending headed its way in part because the FHA has recently increased rather sharply the insurance premiums charged to borrowers. Private mortgage insurance companies, meanwhile, have begun to remove certain restrictions, or so-called “overlays,” that had limited the loans to a smaller group of borrowers. Better terms and growing availability of private mortgage insurance has made it possible for more lenders to offer low-down-payment mortgages that can be sold to Fannie.

Fannie doesn’t disclose how many home-purchase loans it purchases or guarantees with 3% down payments, but private mortgage insurers have reported an uptick in their insurance volumes of those loans. MGIC Investment Corp. said its 3%-down loans accounted for around 5% of its business during the second quarter, or around $480 million. That was up from 2.8% in the year-ago period, or around $165 million.

Some mortgage bankers say the change being considered by Fannie wouldn’t be that disruptive to the market because the FHA will continue to accept loans with 3.5% down payments, even though those loans are more expensive. “An awful lot of people who have only got 3% down would be advised to save another 2%. That’s an old hard-headed answer, but it’s true,” said Lou Barnes, a mortgage banker in Boulder, Colo.

The higher insurance premiums that borrowers have to pay on a mortgage with a 3% down payment, versus one with a 5% down payment, is often enough to warrant “waiting six months or a year to save up the extra down payment,” he says.

How many people knew that Fannie and Freddie underwritten a 3% down payment loan?  I didn’t.  Now, with mortgage insurance being realistically priced to reflex the risks I doubt they will exist in the future.

Low down payment loans equal more risk, it’s as simple as that.  There is very little skin in the by the borrower if the house’s value is below amount owed by the borrower.  Defaults rates increases the with higher Loan-To-Value ratios and borrowers have little motivation if they only put in $6,000 for a $200,000 homes if we use the national median as a example .    There is an even low down payment assistance programs, so some borrowers might put down only .5%, less than 1% of the purchase price.  Government insurance kicks when there are defaults, which costs the tax payers.  There was a reason why down payments are traditionally around 20%, beyond it’s a sign of responsibility to obtain a loan.  The larger down payment protects the lender or if it’s a government sponsored loan the taxpayers, from losses if the borrower defaults on their loans.  This probably a good sign that these mortgages are become a much smaller part of the market place.