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Subprime Swoon Sparks an FHA Revival

Laurie Kulikowski

While a number of lenders already make FHA loans, several others, including IndyMac (NDE Quote) and Bank of America(BAC Quote), are starting to make a bigger push into FHA lending.

"Because underwriting has tightened so significantly, you're going to see people turning back to FHA to get first-time buyers into homes," says Kurt Pfotenhauer, the senior vice president of government affairs for the Mortgage Bankers Association. "We do think we will see some increase in FHA volumes in the coming year."

The news comes as banks and other mortgage companies struggle to replace the outsize profits made in recent years by lending to home buyers with less-than-pristine credit.

The so-called subprime market, covering the borrowers with the worst credit histories, has ground to a halt after a spike in defaults and delinquencies on recent loans drove dozens of lenders out of business. One of the biggest subprime issuers, New Century (NEWC Quote), filed for bankruptcy earlier this month.

Also affected has been the market for what's known as Alt-A loans, those made to borrowers with better credit histories but without full documentation. IndyMac is among the lenders that has specialized in that market and has seen its shares tank as investors worry about credit quality up and down the mortgage spectrum.

The Pasadena, Calif., company is the nation's second-largest independent mortgage lender. It plans to promote the FHA loan products, among others, to offset a decline in origination volume from tightening its lending standards, it says.

In August, Bank of America launched a "national government fulfillment center" in Jacksonville, Fla., to underwrite and fulfill FHA and other government-backed loans.

American Home Mortgage(AHM Quote), which recently disclosed significant problems with its Alt-A business, was the No. 4 issuer of FHA loans last year. Wells Fargo(WFC Quote), Countrywide(CFC Quote) and National City(NCC Quote) were the top three issuers of FHA loans, according to HUD data.

Lenders are returning to FHA loans as the decadelong surge in U.S. home prices appears finally to have crested. An accelerated ramp-up in prices in recent years fed the move away from FHA loans and into more-profitable, less labor-intensive subprime and Alt-A deals.

As a result, FHA loans have been losing market share, as housing prices soared past FHA caps and lenders shunned time-consuming and costly federal underwriting standards.

"There is no low-doc, speed-easy docs done through the FHA," says Frederick Cannon, an analyst at Keefe Bruyette & Woods. "As a result, it tends to be documentation-heavy and slow. It's not terribly profitable. All these companies that made so much money in subprime loans could have been making FHA loans. There is a reason why."

Last year, just 314,000 FHA-insured loans, totaling $40 billion, were issued, according to the Department of Housing and Urban Development, or HUD. In comparison, $600 billion -- or 20% of the total mortgage originations last year -- were subprime loans, according to Inside Mortgage Finance.

But under current FHA requirements, approximately 18% of the "pre-reset" subprime adjustable-rate mortgages, which includes those originated last year, could qualify for an FHA loan, according to an industry report by Citigroup analysts.

"We wonder why so many subprime borrowers qualified for FHA loans," the analysts wrote. "It might be that brokers have had more incentive to steer homebuyers towards an easier-to-procure subprime loan than a tougher FHA mortgage process. However, in the current environment, when new production volume is depressed and length of processing times are no longer an issue, it might become worth their while to go through the FHA loan process after all."

The 73-year-old FHA, which is now a unit of HUD, was originally created to assist low-income and minority borrowers buy homes. But these borrowers -- likely candidates to have trouble making mortgage payments -- often end up in the riskiest loan categories, which forces them to pay high interest rates. The FHA insurance policy gets the borrower a better rate and provides relief to the lender if the customer defaults.

Not all lenders are rushing to offer FHA loans. Last summer, Washington Mutual(WM Quote) exited the business of offering loans backed by government agencies in order to pursue "higher margin products."

In July, it sold its entire $140 billion government mortgage portfolio and servicing operations, which included a portion of its conforming fixed-rate servicing portfolio, to Wells Fargo.

While the Seattle lender says it has no plans to re-enter the FHA business, perhaps it sold the business too soon. WaMu's earnings were crushed in the first quarter by weak performance from its subprime loans.

Changes in FHA lending standards might not be far off. Several bills proposing to update standards have gained traction in Congress over the past year. Proponents are even more insistent that loan standards be updated, since the industry saw a surge in subprime loan defaults in the past few months.

Among the issues that proponents say are in most need of reform are the elimination of a mandatory 3% minimum down payment for an FHA-backed loan, an increase in FHA loan caps to conform with the generally rising prices in the housing market, and the creation of a new insurance-premium structure that would match the credit profile of the borrower instead of a standard premium amount.

"The bottom line is that as lending practices have evolved and modernized, the FHA has not had the ability to fully adapt to the new marketplace and become a viable alternative to subprime loans without congressional approval," says Stephen O'Halloran, a spokesman for HUD.

Passing new legislation to improve the profitability of FHA loans will be crucial to getting more lenders on board with them.

"There are cost savings to be had from the kind of efficiency that FHA will get from a reform from Congress," Pfotenhauer says.