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Updated on Tuesday, April 7, 2015
This morning, American Banker reported that risky mortgages are increasingly being underwritten by thinly capitalized non-banks and guaranteed by the Federal Housing Administration (or FHA). In 2012, when this data was first tracked, large banks represented 65.4% of FHA-backed loans. That number is now 29.6%. In their place, non-banks now represent 62.2% of the FHA lending.
This is important for a few reasons. Small, non-bank mortgage companies have limited financial resources, and certainly do not have the implicit guarantee of a government bailout. If non-bank mortgage companies originate loans of poor credit quality, they could be forced to buy back those mortgages from the FHA. However, given the limited capital cushion that most of these lenders have, even a small uptick in buybacks could bankrupt the small mortgage company and leave the FHA on the hook.
It Is 2007 All Over Again, Almost
There are a lot of opinions on what caused the mortgage crisis in 2008. However, one area of agreement is that underwriting standards became incredibly lax during the boom. In particular, lenders would make loans to people with very bad credit scores, no down payment and no verification of income or employment.
Fannie Mae and Freddie Mac have tightened their lending requirements considerably. However, the FHA is still pursuing a goal of increased homeownership at almost any cost.
You can get an FHA loan with a credit score as low as 500, so long as you have a 10% down payment. And once you hit a 580 credit score, you only need a 3.5% down payment. Credit scores below 600 usually mean that you have significant derogatory information on your credit report. Scores this low result from missing multiple payments on credit cards and loans, having multiple collection items or judgments and potentially having a very recent bankruptcy or foreclosure.
The FHA defends itself by claiming that it completes full income verification, which wasn’t conducted during the last boom. However, income verification only makes sense if there is a reasonable debt burden requirement. A debt burden measures the percentage of your monthly income that goes towards the monthly payment on your debt. The FHA is exempt from the qualified mortgage requirement of a 43% debt-to-income ratio. As the American Banker reported, many loans have a debt-to-income above 55%. Even worse, the FHA only looks at mortgage payments in their calculation.
These are scary levels for monthly payments. If you make $3,000 a month and have a $1,500 monthly payment for your mortgage alone, you are at significant risk for a future default.
The only mitigating factor is the down payment. However, even here, the FHA is willing to accept a gift or inheritance as a down payment. So, you could have no savings, a 500 FICO, a 50% debt-to-income and an inheritance and that would be sufficient to get you a loan.
It is true that these loans do not look as crazy as some of the no income, no job, no asset loans that were made in 2007. However, these are still very high-risk mortgages. There is a reason that large banks, under intense regulatory pressure, are staying clear of these loans. But for scrappy entrepreneurs, many of whom were active during the last mortgage boom, they see a goldmine.
Heads I Win, Tails You Lose
Nonbank mortgage companies don’t worry too much about the increased risk that they are taking. They are willing to take a risk, because there is a big difference between the risk that faces the company, and the risk that faces the founder.
If you set up a mortgage company, you can take incredibly rich commissions on all loans that you book. In a world of low interest rates, investors are hungry for yield. And an FHA loan provides the opportunity for an investor to receive a good yield and a guarantee from the US government.
The management of nonbank mortgage companies enjoys the rich commissions as the loans are booked. Most of these companies retain very little capital on their balance sheets. Instead, they are paying dividends to the owners as quickly as they can. If a crisis happens later, the mortgage company will go bankrupt. But the owners do not have personal liability.
It makes perfect sense for them to book as much as they can, make as much as they can, and walk away when the music stops playing. And the people ultimately on the hook are taxpayers. The FHA is standing behind these loans.
I Thought We Were Supposed To Fix This
After the crisis, regulators made the large banks even larger. And they are spending a lot of time making sure institutions like Citibank, JP Morgan Chase and Bank of America have a lot of capital and avoid subprime mortgages completely.
And Fannie Mae and Freddie Mac have largely tightened their lending standards.
However, the FHA seems to have avoided the scrutiny of the other players. Their mission is to help people with lower incomes achieve the American dream of homeownership. However, that is being translated into approving mortgages that borrowers may never be able to afford.
Banks are afraid to originate these loans. But mortgage bankers, who have been waiting for the right opportunity to resurface, see the FHA as their perfect tool. And we can expect lending criteria to loosen over time, if history is a guide.
At the moment, taxpayers are still underwriting subprime mortgages. Many of us just don’t realize it.