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:

 

2004

2005

2006

2007

Subprime

18%

20%

20%

8%

FHA

3%

2%

2%

3%

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:

Period

Q2 2008

Q3 2008

Q4 2008

Q1 2009

Q2 2009

FHA Market Share

12%

20%

24%

17%

16%

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.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (21)

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  • Report this Comment On December 10, 2009, at 11:04 AM, monroy1 wrote:

    Your 3 points are very slanted and do not paint the entire picture for FHA loans being issued today! You have failed to bring up many important FACTS in regards to FHA that may change the mind of your readers that are now comparing FHA to a subprime lender thanks to your article.

    1. Market Share - you CLAIM that the current exploding market share is not because there are fewer mortgages being issued now than before. That is completely false. There is absolutely NO WAY that the same number of people are getting new mortgages as they were in the housing boom of previous years! Please provide your number of total mortgages issued in 2005, 2006, 2007 vs. 2009. You also don't take into consideration that with fewer mortgages being issued, elimination of most subprime loans and the increased down payment requirements of conventional loans that it would be a no brainer to have FHA take up more market share. Another point is that FHA is a loan many first time homebuyers get, which happen to be the buyer that does not have a short sale or foreclosure on their credit making them able to buy versus many others who wold love to buy during this time of very low home prices.

    2. Underwritng Standards - the borrower has to be current on everything for at least 12 months. They can not "State" their income as with subprime. Income must be proven. The $8000 credit comes after the purchase, so they do have to have their money in the game initially. The high LTV you are so worried about is with today's market prices, which compare to the home prices of 1998 where I live here in Phoenix, so if FHA were to foreclose on a home today they would probably resell it with very little loss unlike the huge losses taken in from previous years that had significant value decreases in the homes that were foreclosed. You failed to mention that the homes must be "Owner Occupied" and if the borrower owns more than one home rental income is not taken into consideration for qualifying another huge difference between subprime and FHA.

    3. Sure there are foreclosures and there will continue to be as long as people are losing their jobs. The current home prices are at a low and there is a cap on how much FHA will lend in every area. Many of the people I know that have recently purchased with FHA could easily rent out their home if they fell on hard times vs. the people of previous years who were so upside down in value that the rental income they could have received would have given them a negative cash flow, which is why many chose to walk away from the home.

    My final point is that given the market share FHA currently has...it is obvious we NEED FHA. The housing market is in crumbles and FHA is helping to bring it back to life. We dont need negative things written about something that is helping many borrowers realize their dream of homeownership. If you want to scare people and if you are a "doom and gloom" type of person that is fine, but list all of the facts and figures, so people can make an informed opinion of their own!

  • Report this Comment On December 10, 2009, at 11:31 AM, BMFPitt wrote:

    The FHA, as well as every other government prop holding up the housing bubble (yes, it's STILL a bubble) needs to be eliminated. The mortgage interest tax credit should be phased out as fast as possible (no more than 5-10 years.) Those who voted for the $8000 bribe should be physically thrown out of Congress.

    Of course none of this will happen. We're all doomed.

  • Report this Comment On December 10, 2009, at 11:35 AM, TMFHousel wrote:

    Monroy1,

    Happy to pick apart your comments one by one:

    “you CLAIM that the current exploding market share is not because there are fewer mortgages being issued now than before. That is completely false. There is absolutely NO WAY that the same number of people are getting new mortgages as they were in the housing boom of previous years!”

    Q3 2009: 2,838,873 mortgage originations, which annualized out to 11.36 million per year.

    2005: 14,490,664

    2006: 12,322,604

    2007: 10,340,762

    2008: 7,573,995.

    So, sure, we’re not quite back to 2005, but somewhere close to the 06-07 level. The fact is FHA is doing over four times as much business today as it did back then. Or, sorry, as you say it, FACTS.

    “the borrower has to be current on everything for at least 12 months. They can not "State" their income as with subprime. Income must be proven.”

    Stated income was hardly a factor contributing to subprime. That was more an ALT-A phenomenon. Subprime was underlined by no down payments and terrible credit scores, which is FHA’s bread and butter, too.

    “so if FHA were to foreclose on a home today they would probably resell it with very little loss unlike the huge losses taken in from previous years that had significant value decreases in the homes that were foreclosed.”

    How about if they foreclose next year? Two years from now? Five? Or are you assuming that home prices can never go down and only go up?

    “The housing market is in crumbles and FHA is helping to bring it back to life. We dont need negative things written about something that is helping many borrowers realize their dream of homeownership.”

    That’s my point, actually. The dream of homeownership for many of these people is just that: A dream. They belong in the renting crowd. For proof, please refer to FHA's current 14% delinquency rate.

  • Report this Comment On December 10, 2009, at 12:57 PM, alexxlea wrote:

    It's sad to say that the phrase we're not out of the woods yet can't even apply to the situation at hand.

    It's more like get used to the woods, kids.

  • Report this Comment On December 10, 2009, at 1:15 PM, monroy1 wrote:

    SISA's and NINA's are subprime loans and were used along with subprime ARM's and NEG Am's that looked great at first until the payments adjusted to levels that were unaffordable to the borrower.

    FHA requires a down payment, it looks at the "Credit Worthiness" of the borrower, looks at the borrowers job history and income. All of which were widely overlooked and many times not required for loans in the subprime market.

    You asked me if I thought home values can only go up. I ask you how much further do you really think home values are going to go down that are in the FHA loan limit range? Do you really think FHA will experience the losses that the subprime market did by loaning money on the home values in today's market? Do you really think that home values in the price range that FHA lends on will be dropping at the same pace it did throughout 06, 07 and 08? Phoenix homes are experiencing multiple offer situations on many homes under $200k just ask someone trying to buy in that price range. This type of activity would indicate that the home values in that range (the FHA range) are pretty well bottomed out!

    You want to refer to a 14% delinquency rate. I say look at how many of those delinquencies correlate with unemployment, job losses or extreme home value decreases. Are the delinquencies the fault of FHA and it's guidelines or are they happening as an effect of another cause?

    FHA is not the "New Subprime Lender".

  • Report this Comment On December 10, 2009, at 2:23 PM, TMFHousel wrote:

    "You want to refer to a 14% delinquency rate. I say look at how many of those delinquencies correlate with unemployment, job losses or extreme home value decreases. Are the delinquencies the fault of FHA and it's guidelines or are they happening as an effect of another cause?"

    Well, prime mortgages have a 6.8% delinquency. People with prime mortgages have to deal with unemployment and extreme home value declines too. If FHA's shoddy lending standards aren't responsible for the gap between 6.8% and 14%, please tell me what is.

  • Report this Comment On December 10, 2009, at 3:19 PM, monroy1 wrote:

    Prime mortgages have a much larger percentage of the market share, so 6.8% is actually almost double the people in default when you compare it to FHA.

    Current economic conditions are hard to base anything off of, because of so many job losses and people choosing to walk away from homes with negative LTV's. Look back prior to 2004 and I would be willing to bet that any upcoming foreclosures for homes purchased in 2008 and 2009 will compare to the amount of foreclosures in years prior to 2004.

  • Report this Comment On December 10, 2009, at 3:31 PM, TMFHousel wrote:

    "Prime mortgages have a much larger percentage of the market share, so 6.8% is actually almost double the people in default when you compare it to FHA."

    It's nearly the double the *amount* of defaults, but the *percentage* of each category is what we're referring to.

  • Report this Comment On December 10, 2009, at 3:49 PM, BMFPitt wrote:

    14% of THEIR mortgates!

    You fail at math...

  • Report this Comment On December 10, 2009, at 5:26 PM, iamkilaru wrote:

    I am heading right to a FHA lender right after work tonight to get a mortgage.....

    why not.... If you cant beat the bully be with the bully.

  • Report this Comment On December 10, 2009, at 5:50 PM, Tinka82 wrote:

    Monroy,

    I'm going to take a stab at your job - Loan officer or mortgage broker perhaps? The following description is in no way intended to pigeon hole or stereo type you personally. Just an industry insider's viewpoint.

    I'm a residential appraiser. I do FHA appraisals, I've done HUD REO appraisals in the past (repos). I've worked for a variety of clients from the most conservative portfolio bankers to the mortgage broker who flat out states he doesn't care what happens tomorrow as long as he gets his YSP and commision check. (yield spread premium to non industry folks. A bonus for upcharging the interest rate to the borrower over what the investor charged)

    Mr. YSP, the latter described individual several years ago often hailed from a subprime churn n burn style shop. Nasty sector of our business. Rude, unprofessional, pushy, unethical, couldn't type a coherent sentence in emails...basically the epitome of the guy who was selling hot dogs last week and got into mortgages this week. The worst of those folks are thankfully gone these days. Those that are left? Well, some of their managers. The ones who didn't train them to do anything but 'produce!!' Picture the movie Wall Street. So the managers share the same lack of ethics, but have a bit more polish and panache. They can write sentences and do almost understand a modicum of the FHA business. But, the huge, huge issue remains in the ethics category. They're still churning and burning.

    Anyone familiar with Lend America? Google them and read up on why they were recently shuttered. Taylor Bean and Whitaker? Similar situation.

    Bottom line is: our minimal downpayment, fully insured by the US Taxpayer, mortgage program has been infiltrated by the ethically challenged loan jockeys that used to largely reside only in subprime world.

    Do we need FHA? You bet. Do we need to be a whole lot more choosey about who are approved FHA lenders, let alone who are FHA borrowers? Indeed!!

    It is in trouble, and our debt ridden, bankrupt treasury is the insurance fund that backs the mortgages.

    Scares the living daylights out of me.

  • Report this Comment On December 10, 2009, at 8:15 PM, markyaney wrote:

    Why don't we just merge with England and turn to socialism, with the fed regulated by a dictator.

  • Report this Comment On December 10, 2009, at 8:28 PM, DDHv wrote:

    It makes more sense to prepare ahead of time. That way the passive income is coming to you instead of being taken out from you.

    Read "The Millionaire Next Door" and you will find a strong tendency buy their houses when prices are down. This also helps the guy who wasn't careful, since he would otherwise not be able to sell at that price.

  • Report this Comment On December 10, 2009, at 10:09 PM, mrCatfish wrote:

    This sounds a lot like Canada's CHMC, (Canadian Housing and Mortgage Corp) which is underwriting millions of 5% down, 35 year mortgages and creating a massive housing bubble here.

    You Americans may not know this, but our prices are over and beyond their previous highs and people are going crazy. It's like the crash never happened and it's mid-2007!

    With zero risk to the banks, (our great, conservative banks!), there's no reason to not lend to someone who can just BARELY afford their payments at 2%.

  • Report this Comment On December 11, 2009, at 10:19 AM, Gideon17 wrote:

    There is one important distinction between the subprime market in 2005 & 2006 and the FHA today that could easily lead to an entirely different outcome. That is the position in the housing cycle. A 3% downpayment (or even 0%) is far more likely to be adequate after the bubble has burst (today) than it was when it was about to burst (2006). What constitutes good underwriting ought to change over time to reflect the environment. There is no surer way to problems than by undwerwriting tomorrow's debt repayments based on yesterday's experience.

  • Report this Comment On December 11, 2009, at 12:08 PM, switchingtoguns wrote:

    If you were listeing to the nonstop ads on the radio in 2006 and 2007 it was very apparent that something was very, very wrong with the mortgage industry. I was in Orange County, California during this time remember being in awe of what these companies were peddling. Lots of different players (couldn't keep up with all of them) with no down payment, 50 year mortgages, interest only mortgages and ARMs to accompany the constant "Flip this House" show marathon. Those shows should have been broadcast with the proper "warning do not try this at home" disclosures.

    Underwriting unfortunately seems to always follow the +/- trend of the past and from my experience is cyclical. When delinquencies and inevitablely losses go up the reaction is to tighten up underwriting and loan less. These has the adverse effect of magnifying loss % since the receiveable base is declining. To ignore yield on a portfolio is to paint only part of the picture and to really determine if a given underwriting criteria is sound or folly this must be included. The individual borrower is beside the point as to whether they can really afford this long term. The banks don't care about the person, only the bottom line. Take some lumps on a % of the borrowers but hey look the rest are paying us at 9.5% and we are still profitable!!!

    I totally agree that there HAS to be some skin in the game and that FHA stepping in with the full backing of the taxpayer should not come without verified income and a dp AT A MINIMUM. Come to think of it, seems all the banks should be following this criteria given they to will have their hat in hand for Joe taxpayer to help them when they lose their a** with all the mortgage defaults they still have yet to deal with.

    This mortgage bubble is not even close to being over. So pay back your loans BofA, et al. Make your balance sheets look good (smoke and mirrors IMHO) and oh yeah have you guys heard of the good deal on CDS's? I'm not buying it in fact I already rode in the jetstream of the bank stocks for the past 9 months. Time to get out because I suspect this next year is going to be UGLY with all the ARM resets and backlog of debtors in default.

  • Report this Comment On May 24, 2010, at 12:05 PM, s2kreno wrote:

    One point you are missing is that average credit scores of FHA borrowers have increased from a marginal 621 a couple of years ago to a respectable 693 today. This is because while the agency doesn't require higher scores, its approved lenders do. These higher standards are referred to as underwriting overlays and have been imposed because lenders with excessive defaults can lose their FHA approval, even if every loan they fund is underwritten in strict accordance with FHA guidelines. So while the agency pays lip service to "flexibility" in fact it punishes lenders that approve borderline loans.

    In addition, many prime borrowers have opted for FHA because of the implementation of risk-based pricing by Fannie Mae and Freddie Mac, and they pulling back of mortgage insurers. FHA becomes a cheaper alternative than it used to be.

    And finally, what killed the subprimers was layering of risk -- no income verification coupled with bad credit added to zero down. FHA requires full documentation.

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