The New Subprime Lender

If you haven't heard of the Federal Housing Administration (FHA), you probably will soon. The government housing agency -- a cousin of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), insuring mortgages that banks won't touch -- has a Goldman Sachs (NYSE:GS)-sized PR problem on its hands. And for good reason.

Plenty who follow FHA cant help but note that 1) it's suddenly supporting a vast portion of today's housing market, and 2) it's relying on similar lending standards (or lack thereof) that ushered subprime straight into housing hell. Hence the heckles suggesting that FHA is the new subprime lender.

Housing and Urban Development secretary Shaun Donovan will hear nothing of this, and recently flat out told the House Financial Services Committee that, "FHA is not 'the next subprime' as some have suggested."

He's right, actually. "Next" implies something in the future. What FHA is is the nation's current subprime lender. Let me give you three reasons why.

1. Market share
Just as subprime took a bow, FHA's market share picked up right where it left off. Two tables tell a powerful story:

Share of Mortgage Originations:

Sources: Department of Housing and Urban Development, Harvard University. Note: excludes refinancings.

During the boom years, subprime made up roughly one-fifth of the mortgage market, while FHA held a negligible share. Today, the subprime market is virtually extinct, while FHA makes up about the same one-fifth of the market subprime used to:

Source: Department of Housing and Urban Development. Note: excludes refinancings.

This exploding market share isn't because fewer total mortgages are being issued. In the second quarter of this year, FHA undertook almost the same number of mortgages it did in all of 2006 combined.

Famed value investor Whitney Tilson put this FHA-turns-subprime growth into further perspective, noting: "Thousands of shady subprime mortgage lenders rebranded themselves and are now doing FHA-backed business. Approved FHA lenders grew from just over 9,600 at the end of FY07 to nearly 14,000 today, according to HUD."

So who, you ask, are these new borrowers FHA has scooped up? For that, we have to look at its underwriting standards.

2. Underwriting standards
As uberblogger Felix Salmon writes, "If you have a subprime credit rating of 600, you only need to put 3.5% down to get an FHA loan; even if you have a positively wrecked credit rating of 500, you can still get a mortgage with only a 10% downpayment."

But forget credit scores. Borrowers with prime credit can and will default in droves if their house is sufficiently underwater. There's a reason banks like Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM) have reverted to customary downpayment requirements: A prime borrower with little skin in the game quickly becomes a subprime equivalent.

Feel free to vomit, then, when reading this: "Almost 90% of FHA purchase loans issued between January and August 2009 had loan-to-value (LTV) ratios of 96 or higher, according to written testimony from Robert Story, chairman of the Mortgage Bankers Association."

An LTV ratio of 96 means the borrower only put 4% down. This, though, doesn't tell the whole story. As part of the first-time homebuyer stimulus plan, new buyers can receive a downpayment credit of up to $8,000. From here, it's simple arithmetic: A buyer with an $8,000 downpayment credit can achieve a 96 LTV ratio on any home worth $200,000 or less without putting down a single penny. They have exactly no skin the game, which is a hallmark of subprime mania.

FHA doesn't even try to beat around its shoddy underwriting standards. Its parent's website proudly states:

Unlike conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios.

Because, you know, all that nitpicky stuff just gets in the way.

3. Loan quality
FHA might make a good argument for not being subprime if its loan book didn't erupt with subprime-esque losses.  

Unfortunately, it is.  

Roughly 14% of all FHA loans are currently delinquent, according to the Mortgage Bankers Association. The 2006 and 2007 vintages show delinquency rates at or above 30%, according to Whitney Tilson.

How's that compare to other mortgage categories? Prime mortgages currently have a 6.8% delinquency rate, while subprimers are at 26.4%. So, sure, overall subprime loans are defaulting at heavier rates that FHA. But that's simply because FHA was making so few loans during the peak of housing insanity, when subprime was piling them on as fast as possible.

FHA's 30%-plus delinquency rates on '06-'07 vintages and the 20%-plus delinquency rate on 2008 vintages are subprime loss rates by any definition. You can make Citigroup (NYSE:C) or Bank of America (NYSE:BAC) look like the most conservative bankers around when compared to those rates.

Moving on
Back in April, University of San Diego professor Norm Miller said, "Frankly, I wouldn't be surprised if you called me up in a year from now and asked, 'What do you think about the FHA bailout?'"

Neither would I. But what about you? What do you think about FHA's role in the housing market? Sound off in the comment section below.