A recent government study of the FHA mortgage loan program suggests loan-to-value is a key factor in the likelihood of default, and that any new, higher risk programs should be limited in availability and enhanced by sharing risk.
The 62-page U.S. Government Accountability Office report, prompted by a proposal to eliminate the borrower contribution requirement for the Federal Housing Administration-insured mortgages, found that the FHA might benefit from risk management tools, new loan program guidelines and practices currently used by conventional mortgage companies.
The report said to lower the risk level of new, low or no down payment loan programs, FHA would need to incorporate some of the practices and framework other mortgage institutions use to manage the risks associated with these new or modified loan products.
Examples of this framework include; imposed limits on the volume of new or significantly modified products; required additional credit enhancements, such as higher insurance coverage; and stricter underwriting, such as credit score thresholds.
FHA does sometimes use practices for limiting new product volume but usually does not pilot products on its own initiative, auditors said. The report stated that FHA officials "question the circumstances in which they can limit the availability of a program and told us they do not have the resources to manage programs with limited volumes."
The report also noted that FHA is authorized to require an additional credit enhancement by sharing risk through coinsurance but does not currently use this authority; and that FHA has imposed stricter underwriting criteria, but not the use of credit score thresholds.
A large amount of research GAO auditors reviewed indicated that credit score and LTV ratio were among the most important factors when estimating the risk level associated with individual mortgages, the report said.
The report said one credit score study showed an applicant with a credit score of 728 had a default probability of 1.26 percent while an applicant with a credit score of 642 was more than two times more likely to end up in default (3.41%).
And another report study found that the default rates for mortgages with an LTV ratio of about 95 percent were three to four times higher than those with an LTV of 90 to 95 percent.
The GAO report concluded that while credit score is an effective predictor of default, LTV remained an effective predictor of default and loans with low or no down payment carry the greatest risk. And without compensating measures such as PMI, increased risk monitoring and oversight in lenders, introducing a new FHA no down payment product would expose FHA to greater credit risk.
In response to its findings, GAO auditors advised Congress to consider limiting any new no down payment product it may authorize. It also recommended that HUD, "among other things, consider piloting new or changed products and that HUD establish a framework for when and how to pilot products.