High loan costs cause FHA originations to plunge
FHA loan originations are plunging because high borrowing costs turn off potential buyers, and risks of put-backs make lenders reluctant.
The biggest barrier to first-time homebuyers is saving for a down payment. As a result, most first-time homebuyers turn to the FHA because the FHA only requires 3.5% down, but as everyone who’s gone down that road also quickly learns, FHA financing is expensive; in fact, FHA financing is so expensive, it’s like taking out a 12.4% second mortgage!
Many have quipped that FHA has become the replacement for subprime. They have very low standards for qualification (a 580 FICO score), a very low down payment requirement (currently 3.5%), and as a result, they stepped into the void left by the collapse of subprime lending.
Under direction from politicians to save the housing market, the FHA ignored the real cost of mortgage risk for years as house prices collapsed, and as a result, they face a government bailout. As the losses mount, reality set in at the FHA, and they continually raise the cost of their insurance to cover the losses from their bad loans. This increased insurance cost adds to a borrowers cost of financing, and it serves as a proxy for raising interest rates on borrowers using FHA financing.
The FHA insurance premium is a direct measure of repayment risk divorced from interest rates. Ordinarily, this risk is rolled up into the interest rate, which is why subprime loans used to carry a higher rate. However, FHA loans have the same interest rate as prime customers. Since the FHA insurance premium is an added borrower cost, with a little math, we can calculate the effective interest rate on an FHA loan and see the incremental cost of that last 16.5% of the mortgage is about a 12% interest rate.
The high cost of FHA financing is one of the many reasons first-time homebuying participation is near record lows. And since these high FHA fees are necessary to properly price risk and make the FHA solvent, unless Congress wants to massively bail out the FHA, the fees will stay high for the foreseeable future.
By Alexis Leondis Sep 19, 2014 12:00 AM PT
… Federal Housing Administration loans, given to borrowers with weaker credit scores and requiring small down payments, plummeted 19 percent in the nine months ending June 30 compared with a year earlier. …
The largest U.S. home lenders are curtailing FHA mortgages because of concerns that they will be penalized for what they consider immaterial underwriting errors when loans default.
JPMorgan Chase & Co. (JPM), Bank of America Corp. and other lenders have paid more than $3 billion in fines for originating faulty FHA loans during the housing bubble following lawsuits brought by the Department of Justice and state attorneys general. Julian Castro, secretary of the Department of Housing and Urban Development that oversees FHA, said the agency wants to ease credit by rewriting its handbook to clearly spell out when lenders can be forced to bear the cost of soured loans.
“A big issue is the DOJ settlements and their impact on the lending attitudes of the banks, which is clearly the elephant in the room,” said Brian Chappelle, a former FHA official and partner at Potomac Partners LLC, a consulting firm for lenders in Washington. “The government is worried about access to credit. They’re looking at volume numbers and they know it’s a serious problem.”
Fighting over put-backs will go on for years. Lenders want to originate as much as possible to generate fees, and the fear of loss from put-backs is the only check-and-balance in the system to prevent them from lowering standards to zero like they did during the housing bubble.
The more stringent the put-back rules, the less risk of loss the US taxpayer absorbs, but the fewer loans lenders originate. I anticipate there will be some relaxation of these rules in the next few years, but with the huge financial problems facing the FHA, these rules won’t loosen too much, and in the grand scheme of things, Congress would rather see the market share of FHA dwindle and help private lending take up the slack.
FHA insured 420,709 purchase loans in the nine months through June 30, compared with 516,588 mortgages during the same period a year earlier, according to HUD data. A record 1.1 million loans were backed by FHA in the 12 months ending Sept. 30, 2010. The annual average for the prior 10 years was 589,242. …
So based on those numbers, the FHA is originating the same number of loans as they averaged during the previous 10 years. What’s the problem here? If loan origination volume is the issue, then private lenders need to increase their activity, either through portfolio lending or securitization.
Defaults on these mortgages led to losses that forced the FHA to take a $1.7 billion taxpayer bailout last year — the first in its 80-year history.
This is why standards won’t loosen much.
In 2013, 39 percent of first-time buyers used FHA loans, which generally require 3.5 percent down, compared with 56 percent in 2010, according to data from the National Association of Realtors.
“Access to credit is tightening across the board and the number of people who can get a home is shrinking to the point of code red,” said Anthony Hsieh, CEO of LoanDepot.com, the third largest FHA lender.
A dearth of first-time buyers is pushing down the national homeownership rate, which fell in the second quarter to its lowest level since 1995, according to Census Bureau data.
Higher FHA mortgage insurance premiums are also depressing demand for its loans and the ability of homebuyers to qualify for them. Borrowers must now pay an up-front fee of 1.75 percent of the loan balance and up to 1.35 percentage points in annual mortgage-insurance premiums.
If FHA’s financial report, which will be released later this year, shows the insurer is in better fiscal health, there will be pressure to reduce premiums, said Lawrence Yun, chief economist at NAR.
There will be pressure, but it will be largely ignored.
“There hasn’t been anything like this weak recovery we’ve had over the last five years, …” Weicher said.
It wouldn’t have been so weak if we had purged the bad debts and hit the reset button. Boomerang buyers would be more active and first-time buyers would also be more excited about real estate if prices were back at 2012 levels. But the banks needed to preserve their solvency, so the powers-that-be reflated the housing bubble, and now they feign surprise that buyers aren’t thrilled about paying sky-high prices. Idiots.
Despite the high costs of FHA financing, for those with no moral compunction against strategic default and passing losses on to their taxpaying neighbors, FHA financing offers some unique benefits.
FHA loans as a stoploss
Back in 2006 when I started publicly warning people not to buy homes due to the impending crash, I pointed out to people that there is no stoploss protection in event of a major decline in prices. Leverage works both ways, and the people who were making huge money on small investments were enjoying stellar returns. However, if prices go the other way, the losses are even more brutal.
Another commonly leveraged investment is stocks. People in a margin account can buy twice as much stock as they can afford by borrowing money from their broker. In the event stock prices collapse, the broker will close out an investor’s position before the account goes negative to preserve their original loan capital. There is no such stoploss protection in residential real estate. If house prices go down, people lose money until prices stop going down. They can easily lose many times their original down payment investment.
Well, at least that used to be true…
Now in an era of short sales as an entitlement, borrowers and speculators have no downside risk beyond their initial down payment. If values go down, people simply petition for a short sale, and the lender absorbs the loss. And when that loan is an FHA loan, the lender simply passes the loss on to the US taxpayer.
The incentive here is clear. Everyone should put the minimum possible down payment on a property to minimize their own exposure. If prices go down, they can petition for a loan modification, a short sale, or simply strategically default with no financial repercussions.
The cost of an FHA loan can be viewed as stoploss insurance, particularly in an non-recourse state like California that has notoriously volatile house prices.
FHA loans as a tool to maximize return on investment
There is a strong secondary incentive to put the minimum down when buying real estate. When you calculate return on investment, the denominator is your investment. The smaller this number is, the higher the return. A 3.5% down payment provides six times the return of a 20% down payment. It’s not the great deal zero-down speculators had going during the bubble, but it’s not bad.
FHA loans are best if you might have to move
Shevy and I always tell people they should rent rather than buy if they think they might need to move in three to five years. Our reasoning is simple, since commissions and closing costs are about 8% of the sales price, it takes at least two years if not longer for houses to appreciate enough to get back the down payment. If a buyer needs to move during that time, their down payment is at risk. This is true irrespective of the financing used, but why should a buyer risk their own money when the FHA will assume more than half this risk for them? Given the uncertainties about future home prices, and the potential to need to move, a buyer is well served by passing off as much risk as possible to the FHA and the US taxpayer.
Personally, I probably won’t follow the advice given above. I didn’t create the awful incentives in the system, I just note them and let others decide how they should behave. There are many ways to rationalize passing speculative losses on to the FHA, and it’s not nearly as difficult to rationalize as stealing a house.