New underwriting standards at the Federal Housing Administration fueled by worries over declining loan quality are threatening to restrict access to FHA loans for riskier borrowers across the country. Local lenders say new products from Fannie Mae and Freddie Mac may have contributed to the situation. 

The FHA is hoping to prevent losses to the fund, which insures mortgages guaranteed by the agency. 

In order to do this, the FHA has amended its automated underwriting system, requiring lenders conduct intensive and expensive manual underwrites on any application flagged as high risk. Many smaller institutions refuse to do manual underwrites because the resulting mortgages are harder to sell on the secondary market. 

“As FHA pulls back and shrinks what fits in their underwriting box, we could see fewer of those consumers approved who had pushed the outer limits of approval,” said Ryan Kirwin, executive vice president of residential lending at Envision Bank & Mortgage. “There could be some impact on entrance into the market for some borrowers, but it’s not necessarily a bad thing. Our responsibility is to ensure borrowers have the ability to repay.” 

Why Has Loan Quality Deteriorated? 

Top FHA executives called recent trends in the quality of loans in its portfolio disturbing in a recent letter to lenders. 

Nearly one of every four approved home purchasers had a debt-to-income ratio exceeding 50 percent, the worst since 2000. FICO credit scores have fallen to the lowest level since 2008 – an industry-low average of 670. In the first quarter of fiscal year 2019, more than 28 percent of all new purchase loans had scores below 640.  

Additionally, in fiscal 2018 the FHA saw a 60 percent increase in “cash-out” refinancing as a percentage of all such mortgages. Cash-outs allow borrowers to convert equity into spendable money.  

This deterioration in loan quality can be attributed to changes in the mix of borrowers taking FHA loans. 

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During the subprime era, many higherrisk borrowers were going to subprime lenders, which left the FHA with higherquality loans, said Jay Tuli, executive vice president of residential lending at Arlington-based Leader Bank. 

“There were cheaper or easier options that required no documentation, whereas the FHA requires a lot of documentation,” he said. “When some of the bigger subprime lenders imploded, there was no outlet.” 

Tuli added that the FHA’s mix of borrowers can change significantly if upper and lowertier borrowers change where they are accessing credit 

Cheaper GSE Products Lure Borrowers 

While it has attracted more lower-quality borrowers since the financial crisis, the FHA has also lost higherquality borrowers to Fannie Mae and Freddie Mac thanks to new loan products from the government-sponsored enterprises. 

Fannie Mae’s HomeReady program allows borrowers with a credit score of 620 or above to put down as little as 3 percent opposed to the FHA’s 3.5 percent.  

Unlike FHA loans, HomeReady borrowers may have the option to cancel their mortgage insurance once their home equity reaches 20 percent, which can result in lower monthly payments. Freddie Mac’s Home Possible mortgage product is similar. 

“Our job, and our goal, is to put borrowers in the least expensive product,” Kirwin said. “Fannie’s product is less expensive than the FHA’s. So, when Fannie and Freddie expanded what fits in their underwriting box and adjusted their pricing strategy, those two products became a better product for the consumer. We have checks in place and a responsible compensation plan designed to ensure our loan officers match the borrower with the best possible product.” 

Envision Bank reported in its October 2018 quarterly earnings statement that demand for higher-margin mortgages like those insured by the FHA had dropped. Kirwin said in previous years FHA loans made up about 22 percent of Envision’s residential mortgages. Now, it’s closer to 15 percent. 

Former Rule Offers Clues to Impact 

With the new restrictions, FHA originations are expected to drop further. 

Tuli said the $1.4 billionasset Leader Bank does not do manual loans. Kirwin said Envision Bank has the capacity to do manual loans, but that about 99 percent of originations are done with the automated underwriting systems. 

Bram Berkowitz

Although it’s hard to predict exactly how the new changes will impact the FHA business among local lenders, the agency’s new underwriting standards could have a similar impact as a rule the FHA implemented in 2013, which required manual underwriting of all loan applications with a FICO score under 620 and a debt-to-income ratio higher than 43 percent. 

During the three years this rule was in effect 90,000 of the 2 million originations, or about 4.5 percent, triggered a manual underwrite, according to Brian Sullivan, spokesperson at the U.S. Department of Housing and Urban Development. 

Some mortgage company executives recently told The Washington Post they are bracing for reductions in their FHA business anywhere from 10 to 30 percent. 

Despite the possibility for lower demand, Kirwin said he thinks the changes are prudent.  

“We applaud HUD for noticing these trends and making changes quickly and responsibly even if that means making some borrowers wait until they are more prepared to buy a home,” he said. “Our strategy will be to coach those borrowers that might not have access right now to get them to the point where they qualify for homeownership.” 

New Standards Expected to Depress FHA Mortgage Activity Among Small Lenders

by Bram Berkowitz time to read: 4 min