In testimony before Congress today, HUD Secretary Shaun Donovan announced plans to reduce the risk that FHA is exposed to in its loan insurance operations; these plans, however, will make FHA loans much less appealing to many borrowers, and may slow down the nascent recovery in the housing market.

FHA insures nearly 1/4 of all mortgage loans currently originated, and 50% of all first-time home buyers’ mortgages, so any changes in those loans will have potentially widespread impacts.

FHA is required by law to keep a reserve fund to pay out on loans that they’ve insured, equal to at least 2% of the total amount of all loans currently insured by FHA; a recent audit of FHA’s books, however, found that this year, those reserves dropped as low as 0.53%. Secretary Donovan’s prepared remarks were designed to explain to Congress how FHA intends to get that reserve back up to the required level. Those plans boil down to continuing a few trends that FHA had started in 2008, when it became clear that they would probably drop below the 2% threshold: insuring fewer risky loans, and collecting more money on the loans that they do insure.

Donovan proposed 5 specific changes to FHA’s policies; the first is fairly non-controversial, but the others are all potential game-changers for the real estate market given FHA’s huge share of current mortgage originations.

The common sense proposal involved stepping up enforcement against lenders who issue FHA loans that end up not actually meeting FHA guidelines, including punishing parent companies of branches that violate FHA rules (since FHA can currently only punish individual branches).

The more controversial proposals were:

• Reducing the maximum seller contributions from 6% of the loan amount to 3% of the loan amount. That 3% cap is the cap that is in effect for most conventional loans, and 3% can usually cover most if not all of a buyer’s closing costs, but the ability of the seller to provide extra assistance over and above the regular closing costs to “buy down” a purchaser’s interest rate is a very important factor in whether many buyers are actually able to afford the payments on the properties that they buy. As a result, the risk reduction effects of this move are questionable; it’s not immediately self-evident that reducing the ability of a buyer to get a lower rate wouldn’t actually increase the number of defaults that result as buyers stretch themselves too thin making higher payments.

• Increasing the minimum FICO score for borrowers. FHA formerly had no minimum score as long as the rest of the borrower’s file made sense; they recently instituted a minimum FICO for automated underwriting approval of 580 and a hard floor for manual underwriting of 500, and Donovan says that those floors will be raised again, although he says that they have not yet determined the new levels. Most lenders have currently set the floor for FICOs for conventional loans in the 640-680 range, so raising the floor for FHA will remove the only remaining option that many borrowers in the high 500s and low 600s have–including many who might otherwise be good candidates to purchase homes but who because of imprudent/unlucky circumstances after the boom years may have had to go through a short sale, which can significantly lower FICO scores.

• Raising the minimum down payment on purchases. Last year, FHA raised that minimum from 2.25% to 3.5%; they are now planning to raise it again, although they again have not yet decided on the exact amount of the change.

• Increasing the mortgage insurance premiums on their loans. Currently, most FHA loans charge mortgage insurance in two parts: a 1.75% upfront fee (usually rolled into the loan by the buyer), as well as 0.55% annual fee (split into monthly payments of 0.04853% per month). FHA is legally allowed to increase that upfront fee as high as 3%, and Donovan implied that they might do so; the 0.55% annual fee is as high as FHA can legally charge at the moment, but Donovan asked Congress to increase that limit so that FHA could increase the annual fee as well.

Even if Congress does not authorize the higher annual fee, increasing the upfront fee to its current statutory maximum would have the effect of making FHA mortgage insurance roughly comparable to privately available mortgage insurance. One of the biggest advantages of FHA loans, and the reason that borrowers are often willing to put up with the sometimes more complicated process of obtaining them, is that they have lower mortgage insurance costs than comparable conventional loans with the same down payment, but if that advantage goes away AND the minimum down payment is increased to roughly the level where the private market is already allowing mortgages (currently a minimum of 5% down), then the advantages of FHA loans will be essentially eliminated.

And if a quarter of all mortgage loans currently are using FHA presumably because they can’t qualify for the conventional option, and then FHA guidelines and rates are essentially brought in line with the private market, then we would expect that quarter of the market to no longer be able to purchase homes; the end result is that purchase volumes would probably drop by about that much.

We’ll be following these proposed changes closely and will keep you informed as more details emerge.

Possibly related posts (automatically generated):

1. HUD Increases FHA Mortgage Insurance Premiums
2. 2009 FHA loan guideline update
3. FHA changes mortgage insurance premiums
4. Buyer-Paid Private Mortgage Insurance (PMI) now deductible.
5. USDA GRH mortgages
6. Reminder About Upcoming FHA MIP Increase
7. HomePath Mortgages Allow Easy Purchase of FNMA Foreclosures
8. Flood Insurance Unavailable Due To Congressional Error
9. FHA/VA Adjustable-Rate Mortgages Can Be A Great, Safe, Deal
10. Condos With High Investor Ratios

Tags: fha, mortgage