FHA to Tighten Lending Standards as Defaults Rise

On the heels of our report detailing short-sale flipping and other kinds of mortgage fraud that are on the rise, the Federal Housing Administration plans to announce it will tighten lending standards to try to stem rising defaults.

The Washington Post reports Housing and Urban Development Secretary Shaun Donovan will tell the House Financial Services Committee that the agency wants to increase the up-front cash paid by borrowers,  raise minimum credit scores for borrowers, and limit how much money sellers can kick in, including paying closing costs or giving free upgrades.

The proposals for tighter standards come as the FHA handles a much larger share of the mortgage market than in the past, and more of its loans go bad. As we explained, FHA loan volume has quadrupled since 2006, and a rising number of defaults has prompted fears the agency will be the next in line for a government bailout.

From The Post:

In the past, the FHA has resisted raising down payments or insurance premiums for fear of shutting out qualified borrowers and stunting the housing market’s slow but steady recovery.

But Donovan plans to tell the House committee that the exploding volume of loans the FHA is now handling requires stricter risk controls than the previous administration had in place, according to a copy of his prepared testimony. A recent audit shows that the FHA’s financial cushion already has eroded below the level required by law.

It’s important to connect the dots here, from mortgage fraud schemes to the FHA. Investors that commit mortgage fraud while flipping short sales or through other schemes increasingly have been finding ways to fund their deals through the FHA, as we noted. In some cases, they have been evading FHA anti-flipping rules by setting up land trusts to purchase and hold real estate, and to obscure the identity of the actual purchaser.

As Yves Smith at Naked Capitalism explained, the FHA has been put in a difficult position as a result of the financial crisis:

It is really a shame to see what has happened to the FHA. Prior to the subprime bubble, the FHA has a good record with providing low down payment loans to borrowers. Before readers scoff, it had a simple secret: it screened borrowers. And the old-fashioned process was sufficiently time-consuming that the prospective homeowners also had to grapple with whether they could make the payments…But now the FHA has been assigned a role in the “save the housing market” game plan, which means notions of prudence get compromised.

But it’s even more than that. As we reported nearly a year ago, both the FHA and HUD were mostly ignored during the Bush administration — but now are being called on to turn on a dime and play major roles in saving the mortgage and housing markets.

The FHA must turn itself around and operate at its peak, after years of neglect. While the Obama administration tackles the stimulus plan and other urgent problems, government agencies like FHA and HUD, long relegated to the sidelines, are being called on to ramp themselves up and take on greatly expanded tasks. With the financial crisis so severe, the revitalization has to happen immediately – and there’s no Plan B. Getting these agencies back up to speed is an overlooked challenge facing the new White House regime.

Rising fraud in FHA loans is one example of that challenge. The new rules are a step toward addressing the problem. But the administration also needs to make a top priority of providing the FHA with the resources to put in place additional risk controls and other necessary changes to handle its much larger role. Banks that aren’t lending have gotten most of the government’s attention and money, even as rising fraud in FHA loans is threatening the housing market, and the economy, as a whole. It’s long past time to change that.