Has FHA Underwriting Created a “Recipe for Disaster?”

The Federal Housing Administration needs to rethink the way it layers risk on its loans, in particular for borrowers who have poor credit history and large payment burdens, says a George Washington University study released today.

The report, the third in a series of “FHA Assessment Reports” pinpoints mortgage default criteria for FHA and determines that down payment and equity are only a small component of what’s necessary in determining future losses.

“Our analysis seeks to illuminate the factors that can greatly increase a loan’s risk of default,” said Robert Van Order, professor of Real Estate and chair of GW’s Center for Real Estate and Urban Analysis. “We have found that down payment alone is not the leading cause of default; nor are low down payment loans much riskier than other loans. However, a number of factors working together—poor credit score, a high ratio of debt-to-income and other variables, such as seller-funded assistance—can create a recipe for disaster.”

Looking at FHA lending criteria versus the private sector, the study finds that with FHA guidelines permitting a 95.5 loan-to-value ratio for an individual with a 580 FICO score and debt-to-income allowance of up to 48%, FHA loans in 2008-2009 have a more than 25% chance of default. The comparable private sector loan has a 2% chance.

“For FHA, it’s a simple matter of prudent underwriting,” said Van Order. “When a portfolio includes such a high volume of high risk mortgages to borrowers with significant debt loads and poor credit history, you’re either going to collapse from defaults or be forced to try to recover losses by chasing revenue from premium increases for new borrowers.”

View the report here.

Written by Elizabeth Ecker




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