Think sub-prime mortgages have gone away? Think again. We have one lurking within FHA, with features that are eerily similar to those of the private market that went into hyper-drive in the 2000s, and collapsed in 2007.
The central features of a sub-prime market are:
- Expensive marketing directed to borrowers with very poor credentials and few options.
- Liberal qualification requirements that allow some weak borrowers to be approved.
- Overcharges, with profit margins much higher than those available on other mortgages.
- High default rates.
Expensive Marketing: The techniques used in the two sub-prime markets to target potential customers are the same. A letter I received recently described "an event sponsored by a real estate company/mortgage company to help people that have had a foreclosure or short sale get back into a house. We did a short sale on our house about two years ago. While there our qualifications were checked, and a few days later they approved us." The approval was for an FHA. Other than that, this letter could have been written 10 years ago.
Liberal Qualification Requirements: The private sub-prime market depended on the substantial liberalization of underwriting requirements that arose out of the housing bubble during 2000-2007. The prevailing assumption was that rising house prices would convert the otherwise weak sub-prime loans into good loans -- which they did, until the bubble burst, at which point the default rate ballooned.
In a similar vein, the FHA sub-prime market today depends on FHA's very liberal underwriting requirements. FHA requires a down payment of only 3 percent and has no minimum credit score. Further, the mortgage insurance premium does not vary with the credit score. While FHA borrowers in total have an average score of about 700, a small group of FHA borrowers have scores below 620. This is the sub-prime lender's target market.
Most mortgage lenders do not take advantage of this, imposing underwriting "overlays" which are requirements more restrictive than FHA's. The reason is that they want to retain their status as approved FHA lenders. They know that if the default rate on the loans they submit exceed some limit set by the agency, they will lose their FHA accreditation. None of the 6 lenders offering FHA's on my site, for example, will accept a credit score below 640.
But there is a small group of lenders who will accept any score, their only concern being whether or not they can get it through FHA. Because of what I do, I am solicited by these people every day, and the messages they email me are outrageously misleading and dishonest.
Overcharges: The profit margins for those originating sub-prime FHA mortgages are three or four times as large as those on other mortgages because the borrowers view themselves as dependent on the originator who solicited them. And they are right, mainstream lenders will reject them. Sub-prime FHA lenders are largely shielded from competition.
High Default Rates: FHA loans with very low down payments to borrowers with very low credit scores have very high default rates. Who are these lenders willing to make FHA loans that carry high default risk? As far as I can determine, they fall into two groups. One group intends to make enough money during the period until they are bounced from the program - which could be some years -- to make it worth their while.
A second group will make the occasional high-risk FHA as an accommodation to a referral source, such as a real estate agent or a mortgage broker. The purpose is to encourage the referral source to send them more quality loans. If such lenders keep the number of high-risk FHAs to a small share of the total, they don't endanger their accreditation with FHA.
Implications For Policy: The FHA sub-prime market results in higher losses to FHA, and allows the most vulnerable borrowers to be overcharged. These borrowers should pay more, but the payments should go to FHA to defray the higher loss rates, not to loan originators. The appropriate remedy is to scale mortgage insurance premiums to credit score.
In 2008, FHA attempted to increase mortgage insurance premiums on low credit scores, and to reject scores less than 500 unless the loan-to-value ratio was 90 percent or less. The proposal was shot down by Congress. Premiums are scheduled to rise this year, but will not be scaled by credit score.
The method FHA currently uses to control its losses, which is to blackball lenders whose loan submissions have high default rates, is clumsy and only partly effective. Lenders removed from the program are replaced by others, and lenders who spread their sub-prime loans among larger numbers of good loans are never caught.
Implications For Borrowers: When you need a mortgage, select the lender, don't allow the lender to select you. If you keep getting rejected, go to the qualification page on my web site, see where your credentials fall short, and read the article on how to fix it.