A new study conducted by the George Washington University School of Business (GWSB) has found that the Federal Housing Administration (FHA) is at risk and needs to rethink layering risk— especially to borrowers with poor credit history and high payment burdens. The new report, released by GWSB’s Center for Real Estate and Urban Analysis (CREUA), is the third in its “FHA Assessment Report” series. Co-authored by Robert Van Order, professor of finance, and Anthony Yezer, professor of economics, the report examines data on mortgage default supplied by different sources, concluding that downpayment and equity are not the only things that matter in determining losses.
“Our analysis seeks to illuminate the factors that can greatly increase a loan’s risk of default,” said Dr. Van Order, Oliver T. Carr Professor of Real Estate and chair of CREUA. “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.”
The report, FHA Assessment Report: The Role of the Federal Housing Administration in a Recovering U.S. Housing Market, analyzes credit risk in mortgage lending, finding that while low downpayment lending can be done safely, those loans with the highest likelihood of default are those in which downpayment size, credit score (known as FICO score) and debt-to-income (DTI) ratio, are “layered,” or present in combination. While the FHA has slightly tightened up on layering, the report claims it is still at risk. While the private sector has mitigated such risk by imposing stricter guidelines for low down payment loans, FHA continues to qualify such borrowers for mortgage financing, putting it at risk of being selected against. The report cites FHA’s “political oversight” as a cause of its inflexibility.
FHA guidelines permit it to give maximum financing (96.5 percent loan-to-value ratio) to an individual with a 580 FICO score. Moreover, such borrowers can have a DTI that can reach 48 percent. With such a low credit score and high DTI, the report looks at 2008-2009 data to find that such a loan would have a greater than 25 percent chance of default in a sharp recession. However, in the private sector, low down payment loans (3.5 percent) are generally limited to a borrower with FICO scores of approximately 720 and more manageable DTI ratios, such as below 41 percent. According to the same analysis, such a loan would have about a two percent chance of default. The report makes the point that FHA does not have to mimic the private sector, but it must have the ability to “adjust to changes or it risks being selected against.”
“For FHA, it’s a simple matter of prudent underwriting,” said Dr. 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.”
The report finds that the true value of a borrower’s equity in a house can be masked by the source of the downpayment. The FHA's treatment of loans with seller-assisted financing has been associated with inflated house prices, less real equity in the property, and it has accounted for a significant share of the loan losses eroding reserves. Political impediments have made it difficult for FHA to modify policies toward seller-assisted financing of down payments and closing costs and increased losses to the insurance fund that have required higher fees for current borrowers.