“Again, the truth is finally emerging. FHA’s audit of mortgage loans insured by them in Q1 2014 apparently has uncovered huge, “material” underwriting error rates. If this is true, it goes a long way to disprove the mainstream view that pre-crisis mortgage underwriting deficiencies were a material cause of mortgage (and mortgage securities) losses during the financial crisis…
…How so? Because if these error rates really meant these 2014 mortgages were bad loans (that will cause the FHA insurance fund losses), then FHA, to be prudent, would have to cancel the insurance (for cause) on roughly half the mortgages they are currently insuring and also prohibit most of the mortgage industry from seeking FHA insurance on new bad loans, right? We know this is not happening and not going to happen, because we know that FHA itself does not believe they are insuring many bad loans (my guess is maybe 1% or less). So, the truth is revealed: mortgage underwriting error rates don’t correlate in any significant way to bad loans and credit losses!!!! As I have said before on this blog, mortgage underwriting deficiencies may have ballooned pre-crisis, as a result of loan volume growth (and few loan losses and buybacks for years), but they were not a major cause of mortgage (or mortgage securities) losses. An unprecedented housing bubble and bust (caused by other factors discussed on this blog) and Great Recession caused the losses. Pre-crisis underwriting deficiencies have become a “red herring” and used by Fannie, Freddie, FHA, private investors/plaintiffs and others, who want to blame their own investment decisions and losses (during the unprecedented crisis) inappropriately on the pre-crisis bankers and mortgage lenders.”, Mike Perry, former Chairman and CEO, IndyMac Bank
“In June, the FHA provided a breakdown of 6,645 loans it reviewed in the first quarter (2014) and found that just 16% were deemed acceptable, meaning they had no mistakes. A whopping 48% were “unacceptable,” with material defects while another 36% were considered “deficient,” with errors that could potentially be corrected.”, October 2014, Mortgage Industry Newsletter
FHA Excerpt from October 2014 Mortgage Industry Newsletter:
“Geez there is a lot going on the FHA sector. The Federal Housing Administration wants lenders to make fewer mistakes when writing mortgages for the government insurance program. The agency also wants to serve more borrowers with low credit scores. FHA lenders have already have felt the tension between these two demands. A hard line on defects means lenders are more likely to be on the hook for losses in the event of default, and lower credit scores make defaults more likely. Many FHA lenders have been pulling back from the market for this reason. The FHA expects 75% of the loans it insures from now on will be made to borrowers with FICO scores of 680 or below, but the housing downturn took many of these borrowers out of the home buying market and the FHA is looking for ways to bring them back.
The FHA, however, thinks that the defect rate for FHA loans is still too high and defects on FHA loans appear to be on the rise. In June, the FHA provided a breakdown of 6,645 loans it reviewed in the first quarter and found that just 16% were deemed acceptable, meaning they had no mistakes. A whopping 48% were “unacceptable,” with material defects, while another 36% were considered “deficient,” with errors that could potentially be corrected. Lenders are still trying to get their arms around the FHA’s quality assurance plan announced in March. The FHA has said its “blueprint” for evaluating underwriting defects should reduce lenders’ fears of having to indemnify the agency for losses on loans to riskier borrowers. FHA’s share of mortgage originations has fallen dramatically in the past year. Still, FHA officials have stressed that the agency will not roll back its 1.35% annual mortgage insurance premium or its 1.75% upfront premium, although the industry would view that quite favorably. Though such a change would make loans more affordable, the FHA had to raise premiums to strengthen its insurance fund, which must maintain a 2% surplus. The share of FHA borrowers with credit scores between 640 and 680 “is half the size of what it used to be.” Lenders have essentially retreated from lending to that segment of the market, resulting in the loss of a borrower class over the last 10 years. Since 2013, the FHA has intentionally pulled back from insuring loans to borrowers with strong credit scores and ceded that market share to Fannie Mae and Freddie Mac for borrowers with FICO scores of 680 or more.
As recently as 2011, 65% of FHA’s volume went to borrowers with FICO scores above 680. Those higher credit scores were something of a departure from the FHA’s mission and its history. In 2007, at the beginning of the financial crisis, 55% of FHA-insured loans went to borrowers with FICO scores below 640. Moreover, 30% of those loans were to borrowers with scores 580, which ultimately hit the agency with a massive wave of defaults. The FHA now expects 25% of the loans it insures will be to borrowers with FICO scores of 640 or below. Another 50% will go to those in the middle ground of 640 to 680. The remaining 25% will be to those borrowers with scores above 680. Efforts have been underway to get lenders to remove so-called credit overlays – FICO score requirements of 680 or more that are used to screen out borrowers with a higher probability of default. Some lenders have lowered credit score requirements this year, largely to drum up business. Many others haven’t budged from imposing credit overlays out of fear they will ultimately be forced to eat losses for any FHA loans that default.