Decreasing the Risk in FHA Loans

DS News - Kenall Baer - 09 December 2016

Banks’ share of FHA lending, which is designed to help low- to moderate-income buyers achieve homeownership, has been on the decline for the last three years, falling from 60 percent down to 22 percent, according to analysis from Laurie Goodman and Jim Parrott of the Urban Institute’s Housing Finance Policy Center.

FHA-backed loans enjoyed a surge in popularity in January 2015, when HUD lowered FHA’s up-front mortgage insurance premiums by 50 basis points. FHA saw its market share rise from 34 percent to 40 percent from 2014 to 2015 while private mortgage insurance (PMI) market share dropped from 40 to 35 percent during the same period.

But PMI has pulled back ahead after lowering its premiums for higher credit-score borrowers earlier this year.

Banks have been pulling out for a while, though, according to Urban Institute. In fact, many banks are hesitant to take on FHA-insured mortgage loans because of, one, delinquent FHA loans are costly to service, and two, the lenders don’t want to be sued under some portion of the False Claims Act. JPMorgan Chase largely withdrew from originating FHA loans in late 2015, citing the burdensome regulatory environment and the constant threat of litigation.

What can be done to improve FHA lending by banks? Goodman and Parrott suggest that Ben Carson, or whomever is confirmed to be the new HUD Secretary, can start by removing the uncertainty around the False Claims Act. Currently, the language of the False Claims Act allows lenders to be sued for even the slightest defect in a loan, no matter how immaterial to the loan’s risk, and the penalty can be as large as up to three times the cost of the loan. Many well-capitalized lenders, therefore, have largely withdrawn from FHA lending because the risk of being sued isn’t worth it, Goodman and Parrott said.

“To address this problem, therefore, the HUD secretary can direct his team to develop a hierarchy of penalties that matches this hierarchy of mistakes, so that smaller mistakes get smaller penalties and the heavy hammer of the False Claims Act is used only for the significant mistakes that actually deserve it,” the authors said. “Under this new system, lenders would finally be able to use improved underwriting to guard against the risk of heavy penalty and thus would no longer need to flee the FHA.”

Well-capitalized lenders are also pulling out of FHA lending because it is not economical for them to service defaulted FHA loans, the authors stated. The new HUD Secretary can address this problem by lightening the rules which are most burdensome to lenders, including transferring the property from the servicer to FHA immediately upon foreclosure, allowing it to be sold more quickly; raising the budget to repair badly damaged homes for faster conveyance; and allowing for “servicer discretion and an expanded timeline, where slowdowns in one part of the process can be offset by more speedy action on another.”

If the new HUD Secretary takes these steps, the authors said, it will bring the most well-capitalized lenders back into FHA lending.

“Doing so will require additional funding, however, as FHA will need to overhaul its outdated systems to take many of these steps,” Goodman and Parrott wrote. “But it is well past time to welcome FHA to the modern era, so that it can finally become a counterparty upon which both the market and the many families it was created to serve can rely.”