Borrowers Abandoned FHA for Subprime

The Government Accountability Office released the analysis, which was based on FHA and Home Mortgage Disclosure Act data as well as interviews with officials from FHA and other mortgage institutions. The work for the report, Federal Housing Administration: Decline in the Agency’s Market Share Was Associated with Product and Process Developments of Other Mortgage Market Participants, was conducted from September 2006 through May 2007.

In the 10 years ending in 2005, the FHA market share based on the number of purchase-money loans sunk to 6 percent from 19 percent, with almost all of the decline occurring since 2001, the report said. The percentages translate to 295,000 loans from about 583,000 loans in 2001.

Meanwhile, the subprime share grew nearly every year, rising to 15 percent from 2 percent, with particularly large increases since 2001 — as 10 percent of the growth occurred since then.

FHA additionally experienced a sharp market share decrease among populations where it traditionally has had a strong presence, while the subprime share among those groups rose dramatically. FHA’s market share dropped to 7 percent from 32 percent among minority borrowers and to 10 percent from 26 percent among low- and moderate-income borrowers. Conventional subprime shares among minorities rose 24 percentage points and among the other group rose 14 percent.

But reduced FHA demand “has raised questions about the agency’s role in and ability to adapt to the mortgage market,” the office added.

Furthermore, FHA lost substantial market share, while subprime lending grew dramatically, in geographic areas with higher proportions of lower-income and minority groups, and in areas with relatively low median credit scores and where median home prices rose to at least 75 percent of FHA’s loan limit. In the 10-year period, FHA lost market share in approximately 90 percent of the census tracts included in the analysis. In tracts with both the highest concentrations of minorities and low median incomes, FHA’s market share fell 31 percentage points while the subprime market share jumped 28 percentage points, GAO said.

Factors that have played into the diminished FHA share are the agency’s product restrictions and lack of process improvements relative to the conventional market, which, in contrast, has had product innovations and expanded origination and funding channels, according to the report. Additionally, low interest rates and rising house prices increased demand for conventional loans, especially by subprime lenders, which featured flexible payment and interest options that allowed borrowers to qualify for mortgages despite the appreciations in home values.

More than 75 percent of subprime borrowers opted for adjustable-rate mortgages in 2005. The majority of conventional subprime loans provided higher ultimate costs, partly because initial low interest rates on the loans could increase 3 percentage points in as little as 2 years and two-thirds featured prepayment penalties.

Nontraditional products came to represent a sizeable part of the subprime loans after 2001. Data showed that from the first quarter 2002 to the third quarter 2005, the IO share of subprime loans soared from zero to 29 percent and the percentage that were no- and low-doc loans increased from 30 to 41 percent. Over the same period, subprime loans with piggyback loans jumped from 2 to 33 percent, while subprime loans that were ARMs grew from 68 to 73 percent, with hybrid ARMs representing the majority, the GAO reported.

The subprime market, in particular, had an increase in mortgage originations through third parties such as loan correspondents and mortgage brokers. This has been associated with the decline in FHA’s market share because these originators primarily market non-FHA products. Data showed loan correspondents and mortgage brokers increased their share of subprime originations from 66 percent in 2003 to 81 percent in 2005. Meanwhile, these originator groups originated just 27 percent of FHA-insured mortgages in 2005. Many brokers do not offer FHA loans because they find the financial and audit requirements for participation in the programs cost-prohibitive, GAO reported.

Brokers continue to make large contributions to the subprime market. In the second half of 2006, brokers contributed 72 percent of subprime originations, up 3 percent from the first six months of the year, according to the Mortgage Bankers Association’s Subprime Mortgage Originations Survey released today.

According to GAO, in 2005, slightly less than 80 percent of FHA borrowers were first-time homebuyers.

MBA’s latest research showed that the percentage of subprime loans being used by first-time borrowers increased to 15 percent in the last six months of 2006 from 12 percent in the first half. The percentage of subprime loans used for repeat and first-time home purchase edged up to 47 percent from 46.

Based on loan count, 32 percent of subprime purchase loans were made to a first-time borrowers, rising 7 percent from the first half, according to MBA, which based on data provided by 13 subprime companies, including many of the top 10 subprime originators.

ARM loans, including those with interest-only, accounted for three-fourths of second half subprime originations, growing from the first half’s level of 67 percent, MBA added.

FHA share was also negatively impacted by the government-sponsored enterprises’ development of products featuring underwriting criteria that allowed for higher risks, such as qualifying borrowers to make no down payment.

It was also impacted by conventional market advances in underwriting technology that allowed processing loan applications more quickly and consistently than in the past and broadened their customer base. While FHA implemented its own mortgage scoring tool, TOTAL, in 2004, it was found the way FHA developed it may limit the scorecard’s effectiveness. This may have contributed to lower-risk borrowers in FHA’s traditional market to go to conventional mortgage providers who were better able than FHA to use scoring tools, according to the report.

The conventional market also benefited from growth in private mortgage securitizations, which enabled lenders to sell the loans, transfer credit risk to investors and use the proceeds to make more loans. “Many lenders would not have found subprime mortgages attractive absent the funding and credit-risk transfer features available through securitization,” the report stated.

The “affordability” features that attracted more borrowers to subprime loans than to FHA-insured loans, however, can deter borrowers from refinancing into lower-cost products. Concerns exist about rising long-term borrower costs as subprime loans also have experienced relatively high rates of default and foreclosure. Of 8.37 million ARMs originated in 2004 through 2006, research estimates that 1.1 million would go into foreclosure as they reset over the next 6 to 7 years, according to the report.

MBA’s recent research showed that 55 percent of subprime originations were for refinance purposes, unchanged from the first half. The share of subprime refinances with cashout grew to 87 percent from 75 percent in the first half. The first half’s cashout refinances, however, could be higher considering that 12 percent of refinances then were reported as “unknown” or “other purposes.

The average subprime loan amount was $202,295 in the third and fourth quarters last year, only 1 percent higher than the average in the first six months, MBA added. Owner-occupied homes edged up 1 percent from the first half to represent 93 percent of the second half’s subprime originations.

In addition to being accompanied by higher ultimate costs for certain conventional borrowers, GAO said a smaller FHA share has been accompanied by a worsening in credit risk indicators among FHA borrower loans. Innovations and the use of automated underwriting tools helped conventional lenders expand their presence in traditional FHA submarkets, leading FHA to experience “adverse selection — that is, conventional providers identified and approved relatively lower-risk borrowers, leaving relatively higher-risk borrowers for FHA.”

Changes in borrower characteristics have contributed to a decline in FHA’s financial performance. In recent years, the credit subsidy rate for FHA’s single-family mortgage insurance program has approached zero — the point at which estimated cash outflows equal estimated cash inflows — and FHA has estimated that, absent program changes, the program for the first time would require a positive subsidy in fiscal year 2008.

“Relatively high default and foreclosure rates for subprime mortgages and a contraction of this market segment could shift market share to FHA,” the report read. “The extent to which this occurs will depend partly on the ability of FHA and other market participants to offer mortgage alternatives to borrowers considering or struggling to maintain higher-priced subprime loans.”

FHA’s recent efforts to modernize its products and processes might facilitate any expansion of its role by increasing operational efficiency and flexibility.

“However, attracting subprime borrowers to FHA could also have costs, as some of these borrowers may pose relatively high insurance risks,” the office wrote. “Careful assessment and management of the risks associated with serving these borrowers would be necessary to avoid exacerbating problems in the financial performance of FHA’s insurance program.”

The report follows a legislative proposal HUD submitted to Congress that, among other things, would raise FHA’s loan limits, give the agency flexibility to set insurance premiums based on the credit risk of borrowers, and reduce down-payment requirements from the current 3 percent to potentially zero.

After reviewing a draft of the GAO report, HUD reportedly commented that FHA provides more transparent and lower overall borrowing costs for borrowers than “affordability” loans. Nonetheless, “additional flexibility, new mortgage insurance products, and risk-based pricing” would help FHA to continue serving lower-income and minority households at lower risk to them and with manageable risk to FHA’s insurance fund.