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Enormous Liability Poses Problem for FHA Lending

Wave of lenders cut back on streamline refinances

June 19, 2012

By SAM GARCIA Mortgage Daily

portrait of Sam Garcia

A wave of lenders recently scaled back on Federal Housing Administration streamline refinances. Several of the mortgagees have publicly indicated that the moves are being made due to secondary market conditions or a desire to maintain service to existing borrowers. But what is really behind the retreat are emerging government actions and potentially enormous liability in originating and servicing FHA-insured business.

The retreat began with Wells Fargo Home Mortgage, which issued a "Newsflash" a week ago to all of its wholesale clients indicating that it would no longer accept FHA streamline refinance transactions on loans that it doesn't already service. The new policy, which applies to all origination channels, went into effect on registrations today.

"Wells Fargo is committed to helping borrowers nationwide with their mortgage financing needs, and this decision will help us accomplish that by focusing on borrowers in our existing servicing portfolio," the notice stated.

When asked about why the decision was made, Wells Fargo spokesman Tom Goyda explained in a statement that demand from the company's more than 500,000 existing FHA  borrowers is expected to be high, "and we want to ensure that our existing customers receive a high level of customer service without frustrating delays."

A spokeswoman for PHH Mortgage, which has advised its correspondent clients that it will not accept FHA streamlines on loans it doesn't already service, indicated that the company isn't releasing any information about its decision.

Another third-party lender that made a similar move, Kinecta Federal Credit Union, was willing to go on the record about their decision.

"As we evaluated the FHA streamlined product, we determined that due to limited investors for the product it was not a viable one for our members," a written statement said. "Therefore, we do not offer it to our members at this time."

Lake Michigan Financial Group advised its correspondent sellers on June 14 that it has discontinued FHA streamline refinances altogether, while Stearns Wholesale advised brokers that "unforeseen market changes" have forced it to add a 1.0 loan level pricing adjustment to all FHA streamline refinances.

"It's absolutely true. They have been exiting en masse," according to Thomas P. Cronin, managing director at the Washington, D.C.-based advisory firm The Collingwood Group. "The problem is that with BofA and Citi etc., out of the correspondent space, anyone with an FHA loan has nowhere to go, other than the retail channel of that institution."

Cronin noted that in addition to Wells Fargo and PHH Mortgage, U.S. Bank has also "just basically thrown the product in the trash bin." He finds the moves puzzling given the low cost to process and service a streamline refinance. Cronin speculates that FHA is working behind the scenes to rectify the situation.

Out of the 237,698 refinance transactions for $47 billion that FHA has endorsed so far during fiscal-year 2012, around 53 percent have been streamline transactions.

Dan Thoms, executive vice president at mortgage information provider AllRegs, said that six of the 72 investors his company tracks have pulled out of FHA streamlines. The remaining large investors are staying in the game if they already have the servicing rights, while the other remaining investors are making changes to their minimum FICO scores and overlays.

Behind the recent exits and tightening is the potential liability associated with originating and servicing FHA mortgages, especially streamline transactions, according to Mortgage Bankers Association President and Chief Executive Officer David H. Stevens.

Stevens, who is leaving MBA next month to become president of SunTrust Mortgage, previously served in the Obama administration as Assistant Secretary of Housing and Urban Development and Federal Housing Commissioner.

Many FHA mortgagees are being contacted by the HUD Office of Inspector General about auditing issues, and concerns are increasing about accusations of False Claims Act violations, Stevens said in a telephone interview.

"The real issue here is reps and warrants, risks associated with originating FHA loans and the huge penalties that are involved in the FHA program if you make an error," Stevens said.

He explained that with defects on loans sold to Fannie Mae and Freddie Mac, the worst-case scenario is repurchase liability or indemnification.

But errors or defects discovered on FHA-insured loans that go bad where an FHA insurance claim has already been filed can be considered a violation of the False Claims Act.

"That means you've filed a claim on a loan that should have never been insured in the first place and it violates the False Claims Act," Stevens explained. "So, the difference here is that the False Claims Act comes with treble damage risk, meaning you pay three times the outstanding balance of the loan.

"Not three time the net of the loss; three times the outstanding balance of the loan."

He gave an example where the loan amount was $200,000, the house was sold for $150,000, and the net loss was $50,000. In that example, the cost to the lender is still $600,000.

While the extreme liability applies to both purchase and refinance transactions, streamline refinances have default rates that are twice as high as non-streamline transactions -- including fully underwritten refinances.

Another problem outlined by Stevens is the length of time it takes to foreclose on an FHA loan as a result of the loss mitigation and loss intervention required by law.

"Ginnie only redeems you at the debenture rate, which is a short interest rate, yet you have to redeem the investor at the full note rate," Stevens said. "And so there's a huge delta in costs for servicing an FHA loan when it goes to default."

With the higher rate of default on streamlines, "you're inheriting a much more troubled book in the first place," he explained.

One possible reason that so many lenders have been cutting back on streamline FHA programs during the past month is that they are receiving letters from the OIG or are being contacted by the Department of Justice about investigations -- though this can't be confirmed.

Faced with possible investigations, subpoenas and lawsuits, the atmosphere is one of uncertainty as lenders wait and see how it will play out.

"The real risk ends up being the penalties for violating these things -- anything within the FHA program -- are so much higher than they are for typical investor putbacks," Stevens said. "And that's the real delta.

"And we've never had to deal with that in our past history of the business."

In the past, FHA was a fairly low risk program with very few putbacks.

But the risk has increased considerably given the False Claims Act.

In addition, the cost of servicing FHA loans is much higher as a result of FHA servicer requirements under the National Housing Act.

One example is a requirement in the law that mortgage servicers make face-to-face contact with FHA borrowers within 90 days of default -- a provision that has been around for a long time but becomes significant with elevated defaults. HUD is required to charge treble damages to servicers that don't meet the requirement.

"That's just one item," Steven said -- adding that the act has many servicing standards provisions.

Since there is no limitation, a mortgagee could be hit for treble damages for filing a false claim and again for servicing standard violations.

The potential for such extreme liability has servicers being very cautious -- leading to the curtailment of the FHA streamline transactions.

"If you were to talk to any of the big institutions right now, the big FHA originators, you would find that many of them are actually talking about how much FHA business they really want and how much risk they are taking off their balance sheets," he added.

Stevens warned that if current subpoenas and investigations lead to settlements like the recent $202 million settlement with Deutsche Bank, "that could clearly become a sea change for FHA origination in this country."

Sam Garcia founded Mortgage Daily in 1998 and became its full-time publisher in 2000. Prior to his news career he worked in mortgage lending for two decades.

[email protected]

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