For years FHA would tell people “FHA is not Subprime”. This was true. FHA had a different set of rules that it followed and in some cases was more strict then Subprime, however in other cases, they were much more lenient than Subprime lenders.

In looking for default FHA default rates online, there are many different numbers being thrown around, but all are over 12% in recent years. >12% of all FHA loans are over 30 days late. The more surprising issue though is they have been at that rate of default for several years!

In looking at the FHA program, it has many more strengths than weaknesses. However FHA just like Subprime, Prime, and Alt-A lending, it got away from it’s fundamentals. FHA was introduced to help people get into homes when they couldn’t do so through more conventional methods. Similar to the CRA programs, limited credit, Credit issues caused by medical reasons, or low down payment were all items that could be overcome individually.

The problems arose when FHA started to allow all these issues on a combined basis and didn’t really underwrite to ‘common sense’ methodology.

A big example of this was the “Down Payment Assistance Program” where initially a borrower could be ‘gifted’ the down payment for their house from a family member, a government grant program, their employer, or a church or other non-profit group. Several groups then figured out that they could found a non-profit group, have the seller “gift” the amount of the down-payment to the non-profit, and then the non-profit group would turn around and “gift” the down payment (minus their fees) to the buyer.

In conjunction with this process, many homes prices were increased to cover the “gifted” down-payment funds which artificially inflated the price of homes in the area. These no-down payment loans were made available to borrowers with poor credit histories and many had no verification they had ever even made rental payments! High Debt ratios were permitted and as long as the customer had not paid late on any debt in the past 12 months (unless it could be shown to be medically related) they could buy a home with no money down, and no reserves for hard times!

It was estimated that these type of loans accounted for 1/3 of all FHA loans, but were responsible for almost 2/3 of their defaults! This program was eliminated recently.

Another area where FHA is ultra aggressive is in cash-out refinances. FHA will allow a higher cash out ratio than any other current type of financing. Through conventional terms, a person can borrow up to 90% of the equity of their home if they are accessing some cash. Through FHA this can go up to 95%, and the pricing is significantly better than is available elsewhere. While this is good for borrowers, it is an added layer of risk for tax-payers. 

Once again, the core FHA guidelines and loans are good. When all risk layers are ignored is where we run into problems. Even a seller-funded Down Payment program can be good, if it is limited to strong customers who have other compensating factors. But to ignore all risk factors is like a doctor prescribing the same drug to all patients with varying symptoms. The outcome is devastating!

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There is so much information floating around the market right now that it is hard for seasoned professionals (let alone industry outsiders) to figure out what is going on in the markets. I see article after article blaming different market sectors, and each have their own reason for doing so.

The bottom line is, a particular product didn’t get us into this, being stupid got us into it….

Over the next little while, I will try to address several market factors detailing why certain products were bad, and why others are not.

Let’s start with CRA (Community Reinvestment Act) and other programs targeting “under-served” segments of the population.

These programs have been around for a while, and help people with low incomes or limited credit get into a home. That by itself isn’t an issue. The underwriting guidelines initially included either a requirement for a larger down payment when the customer didn’t have any credit but good assets, or a low downpayment requirement for customers when their credit was strong but they didn’t have the residual income to come up with the down payment.

Where the program got out of hand was when we began giving loans to pretty much anyone… I somewhat frequently saw loans being given to people with no down payment, limited credit, and a high debt to income ratio.

Typical underwriting guidelines require that all this borrowers debt be less than 43% of his income. some subprime lenders would allow up to 55% of the income – and this was considered very aggressive!

The automated underwriting systems that were approving these loans would sometimes approve debt to income ratios of up to 65%!

To give you an idea of how important the debt to income ratio is, let’s take a borrower who makes $4000 a month. Let’s say the borrower was approved for a loan with a debt to income ratio of 60%.

That would leave this borrower with $1600 a month for all his other necessities.

This borrower’s tax bracket for his federal income taxes would be 25%, taking another $1,000 a month…. We are now down to $600 a month to live on. (granted he will get some of this back at tax time due to his interest deduction, but that isn’t an immediately monthly amount) If the borrower lives in a state with State income taxes, that will eat into this further!

When you take utility bills, groceries, gasoline and maintenance for the car, etc, you can see that this borrower will have to quickly make choices on which bills not to pay!

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An interesting headline caught my eye this morning on Housingwire.com. “Economist sees ray of hope for home prices”! You can read the full article here.

While we are not out of the woods yet, the article points out a trend in housing value declines. The rate of decline has been slowing for the last 2 months and appears that it will continue to slow. From October 2007 to October 2008 housing prices declined 10-11%. It looks like the November -7-08 period will be a 9.6% decline. Still a significant decline, but it shows improvement!

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