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FHA Loans: The New Subprime

NEW YORK ( TheStreet) -- Coming financial reform legislation misses the point if it doesn't address the federal government's growing dominance of the mortgage market because the United States is already being set up for another bubble.

Uncle Sam's best role is to set the parameters for the industry, including sane underwriting requirements for banks and non-bank lenders, along with other rules to prevent abusive lending, while slowly weaning the mortgage market off the programs that have helped feed the boom-and-bust cycle.

But Senator Chris Dodd's "Restoring American Financial Stability" bill does nothing of the sort. In fact, the bill doesn't address the future of Fannie Mae (FNM) and Freddie Mac (FRE), or the explosion of mortgages guaranteed by the Federal Housing Administration (FHA) at all.

Why Third Parties Can't Compete (Forbes)

Despite being taken under conservatorship in September 2008, Fannie and Freddie still dominate the domestic mortgage market and the numbers show the government's role has increased even further since the crisis hit. The Federal Housing Administration's mortgage market share stood at about 30% as of Sep. 30, according to its Fiscal Year 2009 report. That's up from just 3% two years earlier. Total disbursements of guaranteed FHA loans for fiscal 2009 were $337 billion, up 83% from $185 billion a year earlier.

FHA Gravy and The Threat to Taxpayers

Now that the subprime market is temporarily dead, FHA loans have become, in some respects, the "new subprime," with borrowers making down payments as low as 3.5%, and qualifying for lower rates than conventional borrowers.

At TD Bank, a division of Toronto-Dominion Bank (TD - Get Report), for example, the best rate listed on its Web site for a qualified borrower taking a conventional 30-year fixed-rate mortgage, making a 20% down payment and paying no discount points, is 5.125%. For an FHA borrower making a down payment of 3.5%, the rate is 4.75%. For an FHA borrower qualified for the "low to moderate income rate," the quoted rate is 4.25%. FHA borrowers pay for government loan insurance that protects the lender, called a mortgage insurance premium, or MIP. The up-front MIP is 2.25%, and the borrower pays an additional annual MIP of 0.55%, which is based on the average loan balance after being fixed for the first five years.

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