Subprime FHA? Why FHA Must Be Modernized

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I am normally a huge fan of the Competitive Enterprise Institute and everything they do to support the cause of freedom in the world. John Berlau, their director of the Center for Entrepreneurship has recently published a commentary which has made its way through the major papers and is available here or here.

In the commentary, Mr. Berlau argues against expanding the scope of FHA and places FHA programs in the same basket as subprime loans by throwing out a few statistics and some anecdotal evidence from particular areas. In the end, although Mr. Berlau does highlight some important areas to watch, he has some of the facts skewed just enough that it puts his conclusions at issue. The commentary states:

For the past three years, delinquency rates on the oh-so-safe mortgages insured by the FHA have consistently been higher than even those of the dreaded subprime mortgages. In the last quarter of 2006, for instance, the delinquency rate for subprimes had increased to 13.33% in the National Delinquency Survey compiled by the Mortgage Bankers Association. But in the FHA category, the rate had risen to 13.46% — “a new record.”

Nationally, FHA-backed loans do have a lower foreclosure rate than subprimes do, but one that’s nearly twice as high as the rate for all mortgages. And in certain regions, FHA-insured loans account for a disproportionate share of mortgage woes.

Please note the logical inconsistency there. Why would FHA foreclosures be lower than subprime mortgages if the delinquency rate is higher? There are several possible reasons which will indicate that FHA loans are a very different bird than subprime mortgages.

The first possibility might be found in the manner that HUD manages their statistics. I know from my own personal past experience examining my company’s default ratios in HUD’s “Neighborhood Watch” system that these statistics are highly unreliable. Once a borrower has ever been 30 days late on the payment, they are never removed from the delinquency statistics. They are always listed as a default in the statistics even after the payments are brought up to date and even if they are never late again. Comparing statistics provided by HUD to statistics compiled on conventional mortgages is not exactly an apples to apples comparison.

Second, FHA was always intended to provide opportunities for borrowers who fit outside of standard conventional underwriting guidelines. However, unlike subprime mortgages which have allowed silly underwriting rules such as not counting anything on a person’s credit report outside the last 12 months against them, FHA requires that the underwriter examine the patterns of a borrower’s entire credit picture and the stability of their income. This extra analysis alone would contribute to a greater percentage of FHA borrowers in a position to “bounce back” from problems.

Third, it is important to emphasize again that FHA was always intended to insure riskier mortgages. Of course, there will be more foreclosures in comparison to prime borrowers. Before indicting FHA solely on the basis of their total foreclosure rate at the moment, one should look at the concentration of those foreclosures. Chances are good that you will find those foreclosures concentrated in areas experiencing isolated economic problems which will always affect FHA borrowers more heavily than others. Further, FHA loans will naturally tend to be concentrated in areas where the home prices are within FHA limits. It stands to reason then, that FHA loans in those areas will be a seemingly disproportionate percentage of foreclosures. This does not indicate that FHA loans were the cause of the economic problems in those areas.

The commentary goes on to state that:

FHA-insured loans have also been at the center of some of the worst excesses of the housing boom, including mortgage fraud, loans made without income verification, and property “flipping” with inflated appraisals. Last month, in a case brought by federal prosecutor Patrick Fitzgerald, a Rockford, Ill., real-estate agent pleaded guilty to conspiring to defraud the U.S. government through the use of phony pay stubs and credit letters to obtain FHA loans for home-buying clients.

First, there has never in the history of the program been a time that FHA has allowed loans made without income verification! On its own, this statement raises doubt about the depth of Mr. Berlau’s analysis. He follows it up with an example of a case brought last month involving FHA loans. So maybe he is saying that fraud equals no income verification. I don’t know. I’m sure I don’t need to break out the details here, but if anyone wants to contact me through the link at the top of the page, I will be glad to send you hundreds of examples of indictments and convictions for exactly the same crimes committed involving conventional loans.

Second, HUD was ahead of the game in taking steps to prohibit property flipping. FHA has no more been “at the center” of the problem than any other type of loan. There are no statistics to support that statement.

Mr. Berlau’s commentary goes on to attach seller funded down payment programs, basically using the same analysis that HUD used when implementing their recent new rule prohibiting such down payment assistance. Whether or not these programs will even continue is up in the air so the issue may therefore be moot. However, the commentary goes on to state:

…A recent paper by HUD researcher Austin Kelly notes that, since 2000, studies by HUD’s Office of Inspector General “have found that sales prices of homes using seller-funded nonprofits tend to reflect the assistance” provided by the charities.

In other words, the buyer’s assistance is frequently rolled into the home price, inflating the value of the home and leaving the FHA — and ultimately the taxpayer — holding the bag for a defaulted loan. And studies also indicate that the FHA will be picking up the tab at a higher level for these loans.

I encourage everyone to read the studies mentioned. They are not as conclusive as HUD and Mr. Berlau present them. In any regard, a column from Realty Times Columnist David Reed which you can find here addresses this issue very well. For my part, the one thing I see missing from all these studies is to account for the unbelievably high levels of mortgage fraud in many of the areas the studies used to draw their statistical samples from. These problems may not be an indictment of FHA loans or of the down payment assistance programs, but rather of the failure across the mortgage industry to control fraud.

Mr. Berlau ends by pointing out that the vast majority of all mortgages, including FHA mortgages are not in danger of foreclosure and warns against any overly burdensome regulatory response. Here I finally agree with him. There is no reason to be over reacting one way or another. FHA needs to be expanded to bring the program up to date and doing so doesn’t leave the taxpayers holding the bag as Mr. Berlau indicates, but there is no reason to make the program into a catch all for every subprime borrower in the country. There are some people who really do need to wait to buy a home.